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Thursday, November 25, 2004

There is a very revealing article on Zhou Xiaochuan recently on the WSJ. First, Zhou is a true technocrat with an in-depth knowledge of economics (though he is still politically savvy). Second, PBOC and SAFE will likely decrease restrictions against taking money out of China (they already have--but more will come), but continue to limit money flowing into China. Trust me, there are still a lot of people who want to move money out of China. Finally, I think this article underscores the infinite patience of the Chinese government. A reader earlier suggests that the Chinese government and international speculator are playing a waiting game to see who will give in first. However, this is necessarily a losing game for international speculators, who are leveraged and have termed contracts. In contrast, the Chinese government can bear the costs (monitoring cost, enforcement cost, cost of sterilizing hot money). Also one has to remember that the government has to bear a cost for revaluating:heighten unemployment pressure, slower growth, and expectation of future revaluation.

China Official SuggestsCurbs on Yuan to Ease
Move to Full ConvertibilityWould Be Taken in Steps,Central-Bank Chief Says
DOW JONES NEWSWIRESNovember 25, 2004
SHANGHAI -- China's central-bank Gov. Zhou Xiaochuan foreshadowed more reductions in the currency controls that restrict the yuan's convertibility, but the central-bank chief stressed that the move to a fully tradeable currency won't be taken in one step.
China repeatedly has stated that full convertibility of its currency, with a value determined by market forces, is the ultimate objective of government's foreign-exchange overhauls. But to get there, China needs to dismantle many of the restrictions on currency convertibility that Mr. Zhou conceded have no purpose but to create an image of a restrictive policy regime.
At a small gathering of Chinese entrepreneurs and MBA students at Peking University's School of Management on Nov. 16, Mr. Zhou made the case for removing some of those unnecessary restrictions on the currency. According to speech notes and a transcript of a question-and-answer session, he said half the items under the country's capital account are already convertible.

Flexibility, or allowing the yuan to trade more freely on the current account within the existing foreign-exchange regime, and full convertibility, allowing free movement of capital in and out of the country, are two different issues. While analysts expect some widening of the yuan's trading band on the current account, officials in China have been reluctant to move swiftly on convertibility, fearing a potential capital flight, especially from the state-dominated banking system.

Even amid those concerns, Mr. Zhou argued the case for streamlining the current system of capital controls. He said China's regulators have found there are still some unnecessary foreign-exchange restrictions that have no effect except creating the perception of being "restrictive."
"We need to get rid of such ineffective restrictions so that the supply and demand on the country's foreign-exchange market can be more price-oriented and let supply and demand determine the price," Mr. Zhou said. He didn't specify which of the remaining restrictions are ineffective, but he stressed than any currency overhaul would be incremental rather that taken in "one step."

Mr. Zhou also rejected the notion that the central bank's Oct. 29 announcement of the country's first interest-rate increase in more than nine years was a sudden decision. "Actually, the talk about a rate rise lasted for a long time before it really happened, so generally speaking, I don't feel it was too sudden," he said.

The central bank's "monetary-policy board discussed" the rate increase "for many rounds" before a decision, he said. "But it isn't necessary for the public to know in advance no matter if it's a rate move or some other kind of monetary policy."
Meanwhile, BOC Hong Kong (Holdings) Ltd. said yesterday that it sees a far smaller chance of an imminent yuan revaluation than market expectations.
BOC Hong Kong -- the local unit of Bank of China, one of the country's four largest banks -- issued the statement in its latest monthly economic review.
"If the yuan is forced to revalue even by a small percentage, suggesting the government is bowing to pressure brought by hot money, it may lead to even greater revaluation expectations down the road," it said.

It suggested Chinese authorities could strengthen measures currently in place to address the problem of money inflows drawn by speculation over the yuan. These include improving procedures and enforcing rules governing banks' foreign-exchange settlements and relaxing controls on capital outflows.

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Wednesday, November 24, 2004

There is a strange story recently about how State Asset Supervision and Administration Commission will conduct an inspection of asset management companies (AMCs) and debt-for-equity swaps that AMCs conducted in the late 90s to relief SOEs. Below is my discussion.

This is very bizarre indeed. Why would they need the SASAC to check up on d-e swaps? First of all, MOF is in charge of monitoring the profitability of AMCs, so they would complain if these d-e swaps were not working out for the AMCs. If there are some sort of financial irregularities associated with d-e swaps, the CBRC would look into it. I see three possible interpretation of this.

The benign version: MOF and CBRC tried to look into the issue, but since they do not control the personnel of large SOEs, they got nowhere. So they asked for SASAC's help. In the spirit of cooperation, SASAC agreed to force SOEs to give over more control to AMCs, which own large stakes in some SOEs.

The bureaucratic in-fighting scenario: I heard from someone that SASAC is fed up with how little power it had and wanted to expand its power. In this case, SASAC is not investigating the SOEs but the AMCs, presumably because the AMCs did something with the shares it received that is not legit. I am not sure what this might be, but perhaps AMCs have inflated the original number of shares they received from SOEs in order to have more stuff to sell to foreigners. Seeing this as a golden opportunity to embarrass the AMCs and the MOF, which is in charge of the AMCs, SASAC is launching this investigation. The ultimate goal is of course to gain control over the d-e swap process.

The elite politics version: This is very far-fetched, but d-e swap was a major invention of the Zhu Administration to relieve the SOEs. This may be either Huang Ju or Zeng Peiyan (not sure who is in charge of SOEs these days)'s attempt to undermine the Zhu legacy and thus possibly the Wen administration. But even I think this probably is not the case. I think the second scenario is the most likely. I guess we will see whether they put the emphasis of the investigation on the AMCs or the SOEs.




Tuesday November 23, 04:58 PM
China To Check Enterprises Involved In Debt-For-Equity Swaps
Yahoo! Finance

BEIJING, Nov 23 Asia Pulse - China is soon to conduct a thorough checkup of the enterprises having executed debt-for-equity swaps with the approval of the State Council, according to the State Assets Supervision and Administration Commission (SASAC).
An SASAC official said the purpose of the checkup is to learn the current situation and existing problems, discover and correct irregular acts, study the policies for the next step work, and prevent financial risks related to debt-for-equity swaps of enterprises.
ADVERTISEMENT
The SASAC has issued a circular on the checkup to the state assets supervision and administration commissions of all provinces, the four state-owned commercial banks, the four financial asset management companies, the China Development Bank and related central enterprises.
The checkup will cover all debt-for-equity swap enterprises approved by the State Council, including registered new companies after debt-for-equity swap, unregistered new companies after debt-for-equity swap, and enterprises already stopping debt-for-equity swaps.
The circular requires the concerned companies to make self-checkup before December 20 this year, and the SASAC will send joint investigation teams in cooperation with the Ministry of Finance, the People's Bank of China, the China Banking Regulatory Commission and the Audit Office to conduct on-site checks in January next year.
Debt-for-equity swaps, which means conversion of debts owed by a company into the said company's shares usually when the company is unable to repay the debts, is aimed to help such companies get out of difficulty.
(XIC)

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Tuesday, November 23, 2004

Two items on foreign exchange. First, Li Rougu of the PBOC has once again tried to dampen expectation of a yuan revaluation, saying that China will not do so "under pressure." However, this could all just be a game they are playing before they actually revaluate. They did something similar before they raised interest rates. The more important issue that I read in a report is that China might simply be unprepared for a wider trading band on the yuan. Even a loosening of 5% will involve reprogramming a lot of forex systems, so they have to get it all ready before the move canbe made. Also, contrary to my previous guess, it doesn't seem like they will switch to a basket peg, since most trade activities are done in the dollars.

The second article from the WSJ further confirms the market's expectation of a continual devaluation of the dollar and revaluation of Asian currencies. I have to say that there is a limit to this, since most Asian countries rely on export to the US and most of their forex reserves are denominated in the dollar. If they revaluate, they will suffer in decreased export and suffer a loss in their reserve. Europe is particularly grapping with the first problem. I think there will be coordinated intervention by Europe, Japan, and perhaps Korea to save the dollar some time soon. In 20 years, when the yuan becomes fully convertible, I am not sure if they will continue to save the dollar.....

By James Kynge in Beijing, Chris Giles in London and James Harding in SantiagoPublished: November 22 2004 In a mark of China's growing economic confidence, the country's central bank has offered blunt advice to Washington about its ballooning trade deficit and unemployment.In an interview with the Financial Times, Li Ruogu, the deputy governor of the People's Bank of China, warned the US not to blame other countries for its economic difficulties.China's custom is that we never blame others for our own problem,?said the senior central bank official.For the past 26 years, we never put pressure or problems on to the world. The US has the reverse attitude, whenever they have a problem, they blame others.?br>Mr Li insisted an appreciation of the Chinese currency would not solve the US's structural problems and that although China was gradually? moving towards greater exchange rate flexibility, it would not do so under heavy external pressure.under heavy speculation we cannot move [towards greater flexibility] and under heavy external pressure we cannot,?said Mr Li. o the best environment for us to gradually move towards a more flexible exchange rate is when people don't talk about it.

His comments will disappoint US, Japanese and European politicians. Pressure has mounted on the Chinese administration to revalue the renminbi or to increase the flexibility of the Chinese exchange rate over the past two years.Mr Li said China could only permit greater renminbi flexibility after creating a domestic financial infrastructure, including reformed banks and developed markets, able to cope with a more liberalised currency mechanism; considering the conditions and the wishes of neighbouring Asian economies on any move towards a more flexible system; and educating people on how to deal with a new exchange rate system, teaching them how to hedge.Mr Li, who spoke before a meeting of the Asia-Pacific Economic Co-operation (Apec) forum last weekend, said China did not want to run trade surpluses or accumulate foreign currency reserves. Its reserves stand at $515bn.If there is a small deficit, we are not concerned. But certainly we don't want to run into the US situation of having a trade deficit of 6 per cent of GDP,?he said.That is not sustainable,?he added. The appreciation of the RMB will not solve the problems of unemployment in the US because the cost of labour in China is only three per cent that of US labour. They should give up textiles, shoe-making and even agriculture probably.They should concentrate on sectors like aerospace and then sell those things to us and we would spend billions on this. We could easily balance the trade. China's timetable for freeing up the renminbi is expected to have an impact on sales of US goods to the mammoth and growing Chinese market as well as the consumption of Chinese goods in America.The recent, adjustment to Chinese interest rates is seen by some in Washington as evidence that Beijing accepts administrative measures that are no longer an effective means of managing an increasingly liberalised market.At last weekend's G20 meeting, finance ministers and central bank governors called for a global effort to reduce trade imbalances, and in partiuclar, the US current account deficit. John Snow, the US treasury secretary, repeated his commitment to work towards halving the US budget defict and to increase net US national saving, which would reduce the current account deficit.But President George W. Bush's assurances at the weekend that his administration is committed to a strong dollar policy appeared to do little on Monday to encourage buying of the dollar, evidence of how far the White House's credibility on currencies has been undermined by the rising deficit. In mid day trading in New York the dollar was at 1.304 against the euro and 103.21 against the yen.

Asia Bets on Stronger Currencies
Investors Jockey for PositionIn Stocks, Bonds on SignsChina May Ease Yuan's Peg
By PATRICK BARTA in Bangkok, Thailand, and ANDREW BROWNE and MARY KISSEL in Hong Kong Staff Reporters of THE WALL STREET JOURNAL

November 23, 2004; Page A2

Asia appears to be in the early stages of a regionwide currency revaluation, partly in anticipation that China will let its own currency float higher sometime in the next year.
From Tokyo to Seoul to Singapore, some investors are buying up large volumes of Asian currencies, a strategy that assumes Asian countries will tolerate somewhat stronger currencies in the year ahead. The South Korean won is trading near its highest level against the dollar in seven years, while the Japanese yen is up nearly 7% since the beginning of October.

Investors also are pouring capital into Asia's equity and bond markets -- a bet that appreciating currencies will boost the value of their assets over time. Meanwhile, a number of Asia's largest companies are drafting strategies to deal with current and anticipated adjustments in Asian currencies, including cutting costs and changing the amount of business they do in dollars.
"There is beginning to be a little smoke out of that volcano that we're going to see something" in terms of stronger Asian currencies over the next year, says Frank Vargo, vice president for international economic affairs at the National Association of Manufacturers in Washington, which long has lobbied for more-flexible currencies in Asia.
Further revaluation in Asia still is far from certain. With export growth slowing across Asia, many governments could decide further appreciation is too risky as stronger currencies could make their exports less competitive by making them more expensive on the global market. Indeed, traders said South Korean authorities intervened to buy dollars yesterday in an effort to boost the dollar and slow the appreciation of the won. (See related article.)
A modest revaluation of Asia's currencies wouldn't solve the gaping U.S current-account deficit. That deficit -- the shortfall on trade and investment income between the U.S. and the rest of the world -- has widened because the U.S. economy imports far more goods than it exports, forcing the U.S. to borrow heavily from China, Japan and elsewhere to finance its purchases. As the U.S. falls deeper into debt, economists warn, some investors might decide to pull their money from U.S. markets. That could trigger a sharp fall in U.S. asset prices and a sudden surge in interest rates, which in turn might cause a global recession.
Meanwhile, a sizable revaluation could create problems for some Asian countries by cutting the value of their huge foreign-exchange reserves, leading to hefty balance-sheet losses. This is especially true for China, which has $515 billion of foreign-exchange holdings, equivalent to about 30% of the country's gross domestic product.
Still, analysts say there are a number of reasons Asian governments may be growing more tolerant of upward currency moves.
For one thing, China has hinted it is planning to relax its currency's tight peg to the dollar as part of a strategy to give Beijing more leverage to cool its overheated economy and lessen tensions with the U.S. (See related article.) Beijing is likely to cap any currency fluctuations within a "small" range and may link the yuan to a basket of currencies, a person familiar with the government's thinking said. This person wouldn't define "small" but said 5% could count as small while 10% would be "big."
If China does act, it could give other Asian governments more flexibility to follow suit. China's neighbors are wary of letting their currencies appreciate too much without a simultaneous increase in the yuan, as doing so would make their manufactured goods less competitive.
Stronger currencies also could help Asian governments take some of the sting out of high oil and commodity prices by giving consumers and factory owners more purchasing power. Inflationary concerns are especially prevalent in South Korea, which is scrambling to avoid "stagflation" amid weak consumer demand and rising prices.
Finally, many analysts believe there is a growing recognition in Asia that the global trade imbalance is unsustainable, and that some appreciation of their currencies is necessary to prevent more-drastic -- and uncontrolled -- moves later on. The recent slide of the dollar against the euro has highlighted those risks, analysts say.
In a conference call with clients last week, Lehman Brothers' global currency strategist, Jim McCormick, said he believes the yuan will be 5% higher by the end of 2005 while some other Asian currencies could rise as much as 15%. "Asia is willing to tolerate much stronger currencies than most were thinking even a few weeks ago," he said.
In one way, Asia is experiencing a reversal of the currency crisis that swept the region in 1997. Then, Beijing helped to prevent a greater rout of Asian currencies by pledging not to devalue, turning the yuan into an anchor of regional stability. Now, the region is looking to China to pull up the anchor so that its currencies can rise in value, a sign the region has weathered the storm and is ready to sail on.
Indeed, in some ways a further decoupling of Asian currencies from the dollar could help aid the region's march to a healthier economy. To ensure their currencies move somewhat in tandem with the dollar, Asian central banks have been buying dollars and piling up foreign-exchange reserves. If they allow their currencies to rise, they will buy fewer dollars, in effect keeping more Asian savings at home, a move that could deepen capital markets in the region.
Even slightly revalued currencies would represent an important symbolic shift for Asian countries, many of which have kept their currencies at artificially low levels since at least the late 1990s. Analysts believe some Asian currencies are between 10% and 20% below the levels at which they would trade if floated freely.
Many Asian companies are proceeding as if further revaluations are inevitable. As it puts together its business plan for next year, South Korea's LG Electronics Co. says it believes the yuan will appreciate between 5% and 10% next year, but it is preparing for a rise of as much as 15% just to be safe.
Investors, meanwhile, are moving money into Asian stocks and bonds.
Many investors have been selling shares of some of the region's biggest exporters, however, a reminder that any meaningful revaluation would likely cause significant pain for many Asian companies in the short run.

Comments:
I guess the yuan will be re-evaluted at a time when it is least expected. Andy Xie says right now there are 1 trillion US$ hedge fund betting on the appreciation of the yuan (the figure looks too high to be true to me, though), so obviously it's not a good time to re-evalute it now. China will try to hold on for as long as possible. But of course foreign investors also know this, so the result of the game will depend on who can hold on longer. a really interesting game to watch.
 
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Monday, November 22, 2004

A reader recently made a good defence of Liu Mingkang as the head of CBRC. I agree that Liu is the better person for the job, but Shang Fulin, who according to rumor will replace Liu, is perhaps a more savvy political player.

Reader:
- Liu Mingkang has only been in post since April 2003, that's only 18months,
- Most players in the financial realm agree that he has achieved considerable work. Governor of Fujian would not really be a promotion. One explanation if he does leave is that he has been too bold in this reforms.
- The Communist Party Plenum, usually a period of appointments and staff turnover, has already passed, and no announcement has been made.
- The appointment has not been leaked to the official press in English(China Daily).
- Shang Fulin has not been popular with Chinese financial markets. His tenure has been marked by a lack of activism, and rumours of his departure were greeted with a sharp rise in stocks.
To make it short, I do not see why the Chinese leaders would want to shoot themselves in the foot with such a move... Do they consider Liu is goingtoo fast? What is your view?

Me:
I completely agree with your reasoning. By economic logic, Liu is the best man for the job. However, things in the world of Chinese politics operate strangely. First, it is by no means certain at this point that Liu will be moved toFujian. As you pointed out, it is still a rumor. However, I asked around in Beijing two weeks ago, and it is still the word among both Chinese officials and western journalists there. The word is that they are waiting for Shang Fulin to finish his training course at the Central Party School. Also, if you have looked at the RMRB, they are now just beginning to make a series of rotations both at the central and provincial level, so it would not be surprising if a rotation in the financial sector is made in the next month or so.

Also, I would not underestimate Shang Fulin. He is a very good political player within the Chinese government. He seldom talks to the Western press, which is actually an asset. But his guanxi with all the other economic ministries are quite good. Although not a technical economist like Zhou Xiaochuan, he is well-respected in the official circle for his in-depth understanding of the banking sector. Although I agree that he is not as good as Liu, the leadership thinks Shang is much more politically reliable, which is important in China.

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Friday, November 19, 2004

Dear readers, just as a matter of policy, I will not respond to comments unless I know the identity of the writer.

Back to business. So, the FT recently published an article outlining the changes in the banking sector in the past year. I have to say that the usual "beginning of the term boost" is at work again. That is, Wen Jiabao, as the new Premier, has enacted a series of pretty bold changes.

It is true that we have not seen this many changes since 1998, and many of these changes are toward a positive direction. However, Liu Mingkang and others also exaggerate the importance of some of the changes.

The most important change is the move to liberalize interest rates "in principle." Explicit interest rate regulations still apply to rural and urban credit cooperatives, but the Big Four banks and the joint-stock banks can now adjust lending interest rates as they please, while deposit rates can fluctuate downward. This is a good time for liberalization since China reduced its bond issuance this year as the economy recovered. With less need to sell bonds to the state banks, the government feels ready to allow banks to engage in more profitable business. Nonetheless, the CBRC and the PBOC will continue to monitor lending interest rates to ensure that they do not go against state interests. Meanwhile, depositors are still stuck with low yield bank accounts, which depress bond prices in the primary market at an artificially low level.

The move to emphasize adjusted capital adequacy ratio (CAR) is nothing new and has been in the works for a few years. Much of the improvement is due to the massive injection from the foreign exchange reserve.

Finally, the move to reform pay scale in the BOC is also not as dramatic as Zhu Min would like us to think. Since 1998, the pay (including bonuses) of bank branch managers have been tied to profitability and non-performing loans of the branches. The Big Four banks have also aggressively reduced branches and retired older bankers in the past few years. The new change presumably will allow BOC to bid for top talent with big bonuses, which hopefully will reduce the incentive forcorruption. However, all the top managers in the banks are still appointed by the Central Organization Department and the CBRC, and I don't think this will change for some time to come.


The FT piece,

Banking sees transformation from Chinese economy's weakest link to tower of strength
By James Kynge Published: November 18 2004 02:00 Last updated: November 18 2004 02:00

The start of 2004 did not look promising for the causeof Chinese banking reform. State banks, many wallowing in bad debts, were engaged in a lending frenzy that even the pro-growth Communist party worried might result in a meltdown.
But after an inauspicious start, the credit splurge has been tempered and so many long-awaited reforms launched that 2004 could yet be regarded as a watershed for the overhaul of one of the Chinese economy's weakest links.
"We have never seen such a rapid change in Chinese banking history," says Liu Mingkang, chairman of the China Banking Regulatory Commission (CBRC). At the same time, he says much hard work remains to be done.
Landmark changes this year have been manifold. Lending rates were liberalised in October, one large state bank is in the midst of a groundbreaking governance overhaul, authorities have recently approved banks to enter the fund management business and new private banks have been set up.
But Mr Liu uses the improvement in banks' capital adequacy ratios (CAR) as a general indicator on the growing strength of the financial sector.
He says by the end of this year the number of banks able to reach the international standard of 8 per cent CAR will have risen by 11 to a total of 19.
CAR is regarded as crucial because all Chinese banks have been ordered to comply with the 8 per cent standard required by the Bank of International Settlements in Basle, Switzerland, by 2007. It is also important because under rules announced earlier this year, banks with sub-standard CARs have to put more funds on reserve at the central bank - thereby hobbling their growth.
The focus on CAR has also been powerful in reining in banks' lending activities this year because the ratio of capital to assets declines as lending increases and Chinese banks need regulatory approval to issue subordinated debt to top up their CAR.
Mr Liu says lending has been brought under control following last year's frenzy. "Credit expansion since the second quarter [of this year] has been steadily keeping a level of 13.3 to 13.9 per cent," he says.
"One thing I can guarantee: Chinese banks will never be crazy," he adds. "In the next three to four years with CAR and risk management we can see the credit expansion speed will be 13 to 16 per cent. I am quite comfortable with that."
Ensuring the quality of these new loans is a separate task, the importance of which is emphasised by banks' historical legacy. Mr Liu says investment into "redundant projects" - those that fall foul of land, environmental and other regulations - is estimated at Rmb800bn ($97bn, €75bn, £52bn), some Rmb300bn of which comes from bank lending.
As the economy cools, banks will have to increase provisioning against such loans turning bad, an imperative that will further impel them to focus on profitable activities, Mr Liu says.
The regulatory squeeze on banks ordered since the CBRC was established in early 2003 has prompted some lenders to overhaul their management and staffing policies.
Bank of China (BOC), one of two large state lenders that hopes to list on the Hong Kong stockmarket, is engaged in far-reaching changes that will see each of its 230,000 staff reapply for their positions.
Following the reform, the current civil service-style pay scale will be replaced by a performance-based system that will reward staff for prudent lending over those whose decisions result in bad loans, says Zhu Min, Bank of China's executive assistant president.
Reinforcing the pressure for better governance is CBRC's decisions to approve the entry of several foreign competitors to take stakes in domestic banks. Mr Liu says nine more foreign banks are in line for permission to team up with domestic counterparts, in addition to the nine already approved.
Private banks too are starting to gain a foothold. Bohai Bank, a private lender based in the northern city of Tianjin, recently won regulatory approval, Mr Liu says. In addition, several former Rural Credit Co-operatives have transformed themselves into private banks serving mainly rural clients.
Private equity companies such as Zhongrui Caituan, a fund based in the east coast boomtown of Wenzhou, are also being given the green light, says Mr Liu, as long as they desist from public placement and use private placement to raise funds.
The last breakthrough reform was the shift in October to allow banks full freedom in setting their lending rates, abolishing the central bank's remit to set a fixed lending rate. A similar reform will eventually be applied to banks' deposit rates but the upper limit on deposits will be maintained for some time, officials say.
Given flexible lending rates, Chinese banks will for the first time be able to price their loans to reflect the risk profile of the borrower. This, it is hoped, will convince loan officers long accustomed to the mores of socialist banking to analyse the risk inherent in each project and lend accordingly.

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Monday, November 15, 2004

Someone asked me today how monetary policy is made in China. Below is my best guess, based on all the available information:

On the policy process of making interest rate, I think it goes something like this: The State Council has regular standing meetings (changwu huiyi) where the Premier probably asks for opinions on monetary policies from the heads of PBOC, CBRC, MOF, and NDRC. All of these guys have their own researchers doing projections and policy proposals. They will present the angle that best benefits their own agency. But most of the time, they just discuss the state of the economy.

If the Premier is really interested in changing something big like the interest rate, it might be discussed formally at the PBOC Monetary Policy Committee, which meets regularly on a quarterly basis, although 2/3 of the members can hold a meeting at any time. The MPC includes PBOC officials, representatives from two of the Big Four banks, as well as MOF, CSRC, SAFE, CBRC, and NDRC. Thus, the MPC is really a bargaining arena for the various agencies. As far as I know, however, the State Council regularly ignored the MPC's recommendations under Zhu Rongji. I don't know what Wen does.

The MPC then passes the recommendation on to the State Council. For something major like interest rates, Wen will most likely hold a meeting of the Central Finance and Economic Leading Group, composed of him, Huang Ju, Zeng Peiyan, Wu Yi, as well as the heads of PBOC, CBRC, CSRC, CIRC, MOF, NDRC, SAFE, SAMC, and most likely Ministry of Agriculture.

But CFELG will also just make a recommendation for the Standing Committee of the Politburo, which has the final say. However, my impression is that the Standing Committee most often goes along with the CFELG's recommendation on something technical like interest rate.

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Monday, November 08, 2004

The Chinese government's trilemma. The article below highlights the trilemma facing banking regulators and central bankers today. First, the government wants to retain low interest rates because liberalized interest rates would increase the cost of bond issuance and the financing of various policy loans. However, if it keeps deposit interest rates low, depositors will withdraw money and speculate it in the informal capital market (see below). The government can try to increase deposit rates without raising lending rates, but that would squeeze banks' profit margin, which would be difficult since they are trying to list two major banks. So, of low bond financing costs, no informal capital market, and high bank profitability, the government can only get two without substantial transaction costs.

For example, you can keep bond financing costs low and no informal capital market by squeezing the banks with high deposit rates and low lending rates, but bank profitability would suffer as they are forced to either lend at low profit or buy low yield bond. If you want low bond costs and high bank profitability, meaning that you repress real deposit rate to negative or nearly zero, then you will have a thriving informal banking sector, as is the case now. So, what does the Chinese government do? It chooses a high transaction cost approach: shut down the informal banking sector. This is very inefficient and is extremely difficult to monitor due to an array of local economic interests against it. Well, until entrepreneurs in Wenzhou sit in the Central Committee, the party will continue to have its own way.




Informal Lenders in China Pose Risks to Banking SystemBy KEITH BRADSHERNew York TimesNovember 9, 2004http://www.nytimes.com/2004/11/09/business/worldbusiness/09yuan.htmlWENZHOU, China, Nov. 3 - The Wenzhou "stir-fry" is not a dish you eat. Butit is giving indigestion to Chinese regulators and could prove troublesometo many investors worldwide - from New York money managers, Pennsylvaniasteel workers and Midwestern farmers to miners in Australia.Here in this freewheeling city at the forefront of capitalism in China, thedish is prepared when a group of wealthy friends pool millions of dollarsworth of Chinese yuan and put it into a hot investment like Shanghai realestate, where it is stirred and flipped for a hefty profit.The friends often lend each other large amounts on the strength of ahandshake and a handwritten i.o.u. Both sides then go to an automatedteller machine or bank branch to transfer the money, which is thenwithdrawn from the bank. Or sometimes they do it the old-fashioned way:exchanging burlap sacks stuffed with cash.The worry for Chinese regulators is that everyone in China will startcooking the Wenzhou stir-fry and do it outside the banking system. In thelast few months, borrowing and lending across the rest of China is lookingmore and more like Wenzhou's. The growth of this shadow banking systemposes a stiff challenge to China's state-owned banks, already burdened withbad debt, and makes it harder for the nation's leaders to steer afast-growing economy.The problem starts with China's low interest rates. More and more familieswith savings have been snubbing 2 percent interest on bank deposits for thedouble-digit returns from lending large amounts on their own. They lend toreal estate speculators or to small businesses without the politicalconnections to obtain loans from the banks. Not only is the informallending rate higher, but the income from that lending, because it issemilegal at best, is not taxed. For fear of shame, ostracism and theoccasional threat from thugs, borrowers are more likely to pay back theseloans than those from the big banks.Tao Dong, chief China economist at Credit Suisse First Boston, calculatesthat Chinese citizens withdrew $12 billion to $17 billion from their bankdeposits in August and September. The outflow turned into a flood lastmonth, reaching an estimated $120 billion, or more than 3 percent of alldeposits at the country's financial institutions.If the bank withdrawals are not stemmed in the months ahead, Mr. Taowarned, "this potentially could be a huge risk for financial stability andeven social stability."With China now accounting for more than a quarter of the world's steelproduction and nearly a fifth of soybean production, as well as some of thelargest initial public offerings of stock, any shaking of financialconfidence here could ripple quickly through markets in the United Statesand elsewhere. For instance, if the steel girders now being lifted intoplace by hundreds of tall cranes in big cities across China are no longerneeded, that would produce a worldwide glut of steel and push down prices.On Oct. 28, when China's central bank raised interest rates for one-yearloans and deposits by a little more than a quarter of a percentage point,it cited a need to keep money in the banking system. Higher official ratesshould "reduce external cycling of credit funds," the bank said in astatement.The main Chinese banks have fairly substantial reserves, but they needthose reserves to cover huge write-offs of bad debts someday. TheInternational Monetary Fund's China division chief, Eswar Prasad, expressedconcern about bank withdrawals in a speech in Hong Kong three days beforethe central bank acted.The hub of informal lending in China is here in Wenzhou, 230 miles south ofShanghai. Some of China's first experiments with the free market began herein the late 1970's, and a result has been a flourishing economy togetherwith sometimes questionable business dealings.Depending on how raw they like their capitalism, people elsewhere in Chinadescribe Wenzhou as either a center of financial innovation or a den ofloan sharks. But increasingly, Wenzhou is also a microcosm of the kind oflarge-scale yet informal financial dealings now going on across the country.The withdrawals by depositors and the informal money lending have spread soswiftly here that it is only in Wenzhou that the Chinese central bankreleases monthly statistics on average rates for direct loans betweenindividuals or companies. The rate hovered at 1 percent a month for yearsuntil April, when the authorities began limiting the volume of bank loans.Borrowers default on nearly half the loans issued by the state-owned banks,but seldom do so here on money that is usually borrowed from relatives,neighbors or people in the same industry. Residents insist that the risk ofostracism for failing to repay a loan is penalty enough to ensure repaymentof most loans.Although judges have ruled that handwritten i.o.u.'s are legally binding,creditors seldom go to court to collect. "If it is a really good friend, Iwould lose face if I sued them in court," said Tu Shangyun, the owner of alocal copper smelter and part-time "silver bearer" - a broker who putslenders and borrowers in touch with each other, "and if it weren't a goodfriend, I wouldn't lend the money in the first place."Violence is extremely rare, but the threat of it does exist as the ultimateguarantor that people make every effort to repay debts. "Someone can hire akiller who will chase you down, beat you up and maybe even kill you," saidMa Jinlong, who oversaw market-driven financial changes in the 1990's inWenzhou as director of the municipal economic reform committee and is nowan economics professor at Wenzhou University.An austerity policy was invoked, its goal to slow rapid economic growth inthe hope of stopping an upward spiral in the inflation rate. With consumerprices rising at 5.2 percent a year despite price controls on many goodsand services, and with less-regulated prices for goods traded betweencompanies climbing nearly twice as fast, people lose buying power whiletheir money is on deposit at a bank.The interest rate for informal loans jumped last spring to 1.2 percent amonth, or 15.4 percent compounded over a year, and has stayed there since.According to the nation's central bank, total bank deposits in Wenzhou havebeen dropping by $250 million a month since April as companies andindividuals withdraw money either because they can no longer obtain bankloans for their investments or because they want to lend the money athigher rates to each other.For lenders, these interest rates are much more attractive than earning ameager 2.25 percent a year, even after the recent rate increase, on adeposit at a government-owned bank. And while Beijing assesses a 20 percenttax on all interest from bank deposits, nobody pays tax on the income theyreceive from lending money on their own, Mr. Ma said.Most informal loans have traditionally gone to relatives or neighbors tofinance the starting of small local businesses. Wenzhou is now one of theworld's largest producers of nonbrand sunglasses; Dong Ganming, the ownerof a 350-employee sunglass factory here, said that his plant was just oneof almost 1,000 here involved in making glasses.Fierce competition has prompted local residents to borrow money to exploitevery possible niche in the industry, with some factories making nothingbut bridges for sunglasses so that they will not slide down customers'noses, other factories making only the lenses and so forth. Any governmentcrackdown on informal loans would carry the risk of stifling highlyefficient small and medium-size businesses that have little hope ofobtaining loans from the state-owned banks, which still allocate creditbased partly on political connections.Mr. Dong said that loans from friends and family allowed him to start hissunglass company with 10 employees a decade ago; he quickly paid off theloans and has been reinvesting most of the profit ever since, putting verylittle into bank deposits. "The interest in the bank is very low," he said."If you invest the money, you can get much more money."But more recently, local residents say, a lot of money has been flowinginto real estate here and in other big cities, especially Shanghai, helpingto fuel double-digit increases in interest rates. Deals increasinglyinvolve people who have no family or neighborhood connection, raising therisk of disputes.Kellee Tsai, a specialist in Chinese informal banking at Johns HopkinsUniversity, said that many overseas emigrants from Wenzhou had also beensending their savings back to be lent at much higher rates here than areavailable in the countries they have moved to.Some local investors have been able to pay for their investments withprofits from businesses here, like Chen Shen, the owner of four shops thatsell shoe-manufacturing equipment to the hundreds of shoe factories thathave popped up in this area. She said she paid cash for an apartment nearShanghai's Bund, its riverfront district, that had appreciated as much as60 percent in less than two years.Still, Chinese regulators do not like the practice, and officials have beentrying to stamp out such operations with limited success. They haveoutlawed the practice of pooling savings into various kinds of informalbanks that make loans for real estate and other investments: organizers aresubject to the death penalty but are rarely caught unless the informalbanks collapse.Oriental Outlook, a Chinese current affairs magazine, reported late lastmonth on the trial of a man accused of operating an illegal bank northeastof here that collapsed a year ago, leading to the filing of more than 200civil suits. Another man who lost money in the scheme, and went bankrupt asa result, assaulted the defendant outside the courtroom, the magazine said.The extent of such pooling is unclear. But it poses the greatest risks ofdamage to financial confidence if bank runs occur at these informalinstitutions, economists agree. Bank runs, with depositors lined upclamoring for their money back, have been an occasional problem aroundChina for years, but always quickly contained as the authorities rushed todistribute as much cash as necessary."The policy with bank runs, even with illegal banks in some cases, has beento flood the bank with liquidity and pay everyone off," said MichaelPettis, a finance professor at Beijing University, who criticized as illadvised the Chinese policy of bailing out even illegal banks. "One of themost salutary ways to let people know not to put money in these is to lettwo or three go bankrupt."

Comments:
Hi Victor: just came across your blog site tonight and spent almost the whole night reading your posts. Very nice and insightful blogs!

A recurrent theme of your blogs is that the central government is not able to completely control the local governments. I have actually been thinking about this for a while, and it always appears a puzzle to me. I mean, although China's economic decentralization has been going on for a long time, the political and administrative system is still very centralized. The central government completely controls the appointment of lower officials, for example. How can local officials defy the policy/commands of the central government under such circumstances?

One possible answer is that the factional conflicts within the central government makes this possible. Especially, many localities have powerful backers in the center. this seemes to be the argument of Susan Shirk's 1994 book, but it has been discredited by Yang Dali in a review article in world politics, as he found that those provinces that have more representatives in the central committee did not get more particularistic benefits from the center.

So what do you think is the cause for this center-local balance? I've recently been thinking that it might be a common agency problem, that is, the local government has two principals: the central government and local businesses (which have bought off local governments). If this is true, it implies that the more economically advanced regions defy the center more often, and maybe the center dismiss officials in these regions more frequently as well (I'm not sure where to find data to test this theory though). What do you think of this explanation?

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Sunday, November 07, 2004

Some comment on the yuan revaluation. It now seems that China will simultaneously widen the trading band for the RMB and switch to a basket peg at the same time. As seen in the article below, international currency traders are expecting a basket peg. For those who bet on the yuan, of whom I am not one, they will likely reap more than expected benefits, since a basket peg will provide the yuan with a further de facto appreciation of 1-2%. While this simultaneous move will attract even more hot money, the Chinese government is opting for its usual tactic of more enforcement of foreign exchange rules. The inspection that SAFE carried out late last-month is likely a preemptive strike against hot money. More such inspections can be expected in the near future. Since everyone knows that SAFE enforcement is far from perfect, real estate prices will likely remain buoyant and perhaps regain upward momentum in the near future. Speculators tend to think the real estate market a safer bet than China's unimpressive stock market.

Although I usually do not comment on US politics, I think the continual slide of the dollar increases the urgency of decreasing the US deficit. The recent slide of the dollar will increase the cost of issuing bonds, which further increases the long-term cost of the deficit. If Bush cares at all about the future of this country, he will have to find ways to cut the deficit.


Dollar expected to fall amid China's rumoured selling By Steve Johnson in London and Andrew Balls in Washington Published: November 7 2004 19:43 Last updated: November 7 2004 19:43
The dollar could slide still further, in spite of hitting an all-time low against the euro last week in the wake of George W. Bush's re-election, currency traders have said.
The dollar sell-off has resumed amid fears among traders that Mr Bush's victory will bring four more years of widening US budget and current account deficits, heightened geopolitical risks and a policy of "benign neglect" of the dollar.
Many currency traders were taken aback on Friday when the greenback fell in spite of bullish data showing the US economy created 337,000 jobs in October.
"If this can't cause the dollar to strengthen you have to tell me what will. This is a big green light to sell the dollar," said David Bloom, currency analyst at HSBC, as the greenback fell to a nine-year low in trade-weighted terms.
The dollar's fall comes as the Federal Reserve is widely expected to raise US interest rates by a quarter point to 2 per cent when it meets on Wednesday and to signal that it will continue with a measured pace of rate increases.
Speculative traders in Chicago last week racked up the highest number of long-euro, short-dollar contracts on record. Options traders have reported brisk business in euro calls - contracts to buy the euro at a pre-determined rate.
However, the market has been rife with rumours that the latest wave of selling has been led by foreign governments seeking to cut their exposure to US assets.
India and Russia have reportedly been selling US assets, as well as petrodollar-rich Middle Eastern investors.
China, which has $515bn of reserves, was also said to be selling dollars and buying Asian currencies in readiness to switch the renminbi's dollar peg to a basket arrangement, something Chinese officials have increasingly hinted at. Any re-allocation could push the dollar sharply lower and Treasury yields markedly higher.


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