Wednesday, December 29, 2004

Saw an interesting op-ed in the FT about foreign exchange reserve and SOEs, but SOE pension obligation is such a passe issue. Much of the problem has disappeared, and the remaining problem is really managable. The problem is continuing soft-budget to SOEs. Below are my responses to the op-ed.

The Chinese government has used the foreign exchange reserve to recapitalize the big state banks, which have poured trillions into SOEs. They are likely to use another 40 to 50 billion USD to recapitalize ICBC and ABC in the future. They might use some of the money to finance the social security fund, but I haven't heard anything about it. Regardless, it is a bad idea to use the money specifically to cover SOE social pension. The SOEs have used social obligation as an excuse to get more subsidies in the past decade. In fact, a modest investment in the early 90s could have saved the Chinese government trillions of yuan in money poured into the SOEs. Zhu Rongji was in fact quite successful in reducing SOE staff as a share of urban employees. The main task now is to establish a national social security system that benefits all workers regardless of where they work.

The problem is that soft budget going to SOEs continues regardless of social obligation. Much of the money going into SOEs is used to finance investment and expansion. Some of the money seemed justifiable, given recent supply shortage. However, there is bound to be enormous distortion in the flow of money to SOEs since banks are still encouraged to lend to SOEs and the SPC still approves major investment of SOEs. As Professor Lal points out, there is still capital control and a repressed financial system. The SASAC is now taking tentative steps toward the final stage of SOE reform, privatization, but ideological, institutional, and legal barriers make this a slow process. Granted, financial liberalization and privatization need to take place gradually, but in the meantime, distortion is the price that one has to pay. So, using the foreign exchange reserve just for SOEs is not a good idea, since they receive plenty of soft-budget already and banks are still not operating independently. The Chinese government needs to diversify, and they are doing so already by reducing purchasing of US treasuries.

Financial Times

How foreign reserves could make China yet strongerBy Deepak LalPublished: December 28 2004 19:36Last updated: December 28 2004 19:36

Foreign exchange in ChinaChina's economic performance in recent years has been extraordinary. This year, growth in gross domestic product is forecast to exceed 9 per cent, with industrial production up a remarkable 16 per cent. Many fear that the country's financial system may be too fragile to sustain such growth in the long term. Fortunately, the country's burgeoning foreign exchange reserves could provide an ideal remedy.At the root of the problems in China's financial sector are the continuing subsidies directed to state-owned enterprises via the banking system. The purpose of these is to prevent unemployment and the loss of welfare benefits to former and current employees. Although the government has closed the worst loss-makers, the remainder continue to be subsidised.In the long term this is likely to damage China's currently high savings rate, the foundation of its economic miracle. At present, nearly 90 per cent of household savings are held in deposits with state-owned banks, partly because of the lack of alternatives. Most of these deposits are lent to SOEs. By contrast, most of the investment in the dynamic, private non-SOE sector that is propelling China's industrial growth is self-financed, or dependent on foreign capital. With few of these non-state growth enterprises being willing - or allowed - to issue shares, trade on domestic stock exchanges is mainly in SOEs, whose non-transparent accounting practices and perceived lack of viability deter households from holding much of their savings in them directly. Hence the thinness and volatility of the domestic stock markets, as even a little news from the opaque SOEs can trigger big price movements.This lack of adequate savings vehicles and the low return on deposits in state-owned banks pose a threat to China's high rate of savings. This is likely to be compounded by the depressing effect on savings of an increasingly elderly population. But the state-owned banks cannot promote higher savings by raising their deposit rates without a rise in their lending rates to the unviable SOEs. These SOEs' losses would then grow, leading the banks to advance more loans to cover them, with the result that the banking system would be burdened with yet more non-performing loans.These microeconomic difficulties in using interest rates to stimulate savings that can then be fed into a well-functioning stock market have macroeconomic consequences. As the central bank is in effect prevented from using the interest rate to manage aggregate demand, heavy-handed (and, given the self-financed nature of most non-SOE investment, inefficient) administrative measures are needed to cool the economy.Furthermore, given the fragility of the banking system, fully opening up the capital account of the balance of payments and moving to a completely flexible exchange rate system is ruled out. I do not think China's export-led growth has depended on maintaining an undervalued exchange rate. As most of China's manufactured exports are processed goods with little domestic value added, changes in the exchange rate would have little effect on companies' profitability. The move to a flexible exchange rate is not only needed for a more efficient use of China's national savings, but also to fend off the growing pressures for a revaluation of the renminbi from private speculators and China's main trading partners.Behind all these dangers to China's economy lie the social burdens carried by the SOEs. These must be removed so the viable SOEs can prosper and the rest can be taken over or closed down.Fortunately, China's large build-up of foreign exchange reserves provides the answer. In October, these stood at more than $600bn, in a roughly $1,000bn economy. They are about 60 per cent of gross domestic product and are largely held in US Treasuries. Apart from the absurdity of a relatively capital-poor developing country making these large, unrequited transfers to a rich country, China must have seen a loss in the real value of these assets. Since its peak in 2002, the US dollar has depreciated by nearly 30 per cent in trade-weighted terms against big currencies.There is a better way for China to use its reserves. At most, only a small proportion - say $100bn - is needed to fend off any speculative attack in order to maintain the dollar peg. The rest - some $500bn, as well as any future accruals - could be put into a social reconstruction fund under the central bank. This would function like any other big pension fund, such as that for the World Bank, whose annual return, averaged over 10 years, has been about 8 per cent. If the proposed fund for China could match this, it would yield an annual income of $40bn, or 4 per cent of GDP, which could be used gradually to cover the SOE's social burdens. The SOEs could then be treated as normal enterprises, to be privatised if viable and closed down if not.This would bring many benefits. It would end the need for the subsidies that are sapping the banking system's vitality. Banks could instead concentrate on mobilising domestic savings and transferring them to high-yielding investment projects. SOEs with market-traded stocks would have more incentive to adopt transparent accounting. The authorities would be able to use interest rates as the primary means of managing demand. With a more robust financial system, the renminbi could even be allowed to float. In time, as the SOE problem receded, the income from the fund could become the basis for a fully funded pensions system for China's ageing population.There are good reasons to worry about the robustness of China's financial system, it is true. But a country with $600bn in reserves is not exactly devoid of options.

The writer is the professor of international development studies at the University of California, Los Angeles

Seeking counsel from elders seems to be a lost advantage. Experience usually translated into lessons learned that may contain pearls of wisdom that could have benefited the lost or struggling. Having survived my share of crises, I am using technology to share a thought or two. The main lesson is to never stop learning. Reading and seeking other points of view like visiting your blog is one way. Finding what is ultimately important leads one to appreciate actuality, efficiency and mindfulness. Helping others to see some of the forest through the trees is a benefit of age and maturity. discernment
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A reporter friend asked me to give a brief outline of the RMB, or the Chinese yuan. Below are my quick response.

The RMB played a peripheral role during the 50s through the 70s mainly as a way to control the supply and demand of non-essential luxury goods. All of the essential goods like food and building material were allocated through the plan, and, as you pointed out, through the coupon system. Cash income in those days was used by residents to buy luxury items like bicycles and radios. After the great leap forward, cash circulation was severely curtailed so that industrial capacity could scale back and focus on the essential. As I mentioned in my chapter, cash was also used by firms to fill unexpected gaps in the annual budget. In theory, all the working capital and investment costs were supplied by the state through the state plan, but firms sometimes needed a bank loan to fulfill unexpected costs.

What happened in the late 70s and early 80s was that the household responsibility system gave peasants much more cash than before, and Deng also raised the urban wage scale substantially. This provided a great boost in cash in the economy,which allowed much more non-state spending and investment. One can say that the large boost in cash in the early 80s was the seed of private sector development in China. Since the state can't control cash once it is circulating, people can take this cash to invest in new firms...etc. These new firms then competed with the SOEs, which created SOE losses but also a vibrant private sector in the 90s.

The amazing thing is that the state continued to print more and more cash over time to pay for SOE losses. While dumping money on loss-making SOEs is bad, increasing cash circulation and financial assets allowed the rest of the economy to finance new investment. This use of money is not the most economically efficient, but new research shows that just by having more money in a non-inflationary environment is in itself enough to generate growth.

The other unique thing that China did was that it maintained a successful capital control regime throughout the reform. The key to this success was that the Chinese government kept foreign exchange spending low and thus foreign debt low. In some Latin American countries, elites competed with each other to borrow as much foreign currency as possible, causing a complete collapse of the fixed exchange rate. So, unlike some developing countries in Latin America and Africa, China was able to maintain capital control with relatively low cost and did not face the financial volatility faced by Latin America. Granted, there were a few close calls (1988 and 1994), but China weathered them.

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Friday, December 24, 2004

I recently had a discussion with a friend about the October interest rate liberalization. In October, the PBOC announced that it would in principle liberalize lending interest rates for major financial institutions. According to a report by an investment bank, banks are nonetheless still charging the official PBOC lending interest rates. The question is why.

Why not take a chance with higher risk loans and charge higher interest. After all, this is what the underground banks have been doing for years. As US lenders have known for years, the "sub-prime" market can be very lucrative. Nonetheless, banks are still reluctant to do so. One reason is that the CBRC still watches NPL ratio very, very closely. This means that banks still would rather lend to safe firms at lower rates than to more risky firms at a higher rate. Bankers are also afraid that too much lending to risky private firms will bring charges of corruption. I just wonder if there is an unofficial policy besides the official one about lending interest rate.

The real test will come if inflation goes up. If that happens, will the PBOC "stand idly by" as lending interest rates climb above the 10% level? Of course, this round of liberalization might suggest that the PBOC is now so confident of its monetary instruments that they don't forsee any inflation problems in the future.

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Wednesday, December 08, 2004

The CAO scandal is interesting, but I think it really isn't a big deal. First of all, if their business is oil, they are most likely profitable in their real business. True, they lost half a billion dollars, but the government can certainly handle it. Below is a hypothetical scene in the State Council:

CEO of CAO: Eh, we lost like 4 billion RMB due a "small minority of people" making a mistake.
Wen: This is very bad. We must maintain international confidence in China by paying off this amount immediately. Xiao Zhou, please take care of it.
Zhou Xiaochuan: Okay, the PBOC will increase relending to Bank of China, and it can make an emergency loan based on the relending to CAO. We will charge the BOC 2.25% in interest, and BOC can charge CAO up to 4% in interest.
Li Lihui (CEO of BOC): Okay, meanwhile, we will roll over any loan CAO had with us so that it does not become non-performing.

Duration: 2 minutes and 30 seconds

Commentary: Is China on the verge of its own Enron scandal?By William Pesek Jr. Bloomberg NewsThursday, December 9, 2004 http://www.iht.com/bin/print_ipub.php?file=/articles/2004/12/08/bloomberg/sxpesek.html
In 2002, China Aviation Oil (Singapore) was named Singapore's most transparent company by the island's Securities Investors Association. No doubt the group is regretting that decision.
The Singapore-based company is being investigated for losses from speculative oil trading that it hid from investors. The $550 million derivatives-trading loss is Singapore's biggest since the trader Nick Leeson brought down Barings in 1995 with more than $1.4 billion in losses. Former Prime Minister Goh Chok Tong says the city's reputation as a financial center will rest on how it handles the inquiry.
Yet China Aviation Oil's story may say less about Singapore than about the risks of investing in the Chinese economy. Could the affair turn out to be the Chinese equivalent of the Enron debacle?
While allegations have yet to be proven in court, the scandal could prompt reassessment of an entire economy and its companies, just as Enron's collapse did in the United States.
China Aviation Oil's woes show how challenges in the Chinese economy can undermine other markets. Hundreds of state-owned Chinese companies have sold shares in Hong Kong, New York and Singapore. China Aviation Oil - a foreign unit of a Beijing company - is a reminder that transparency and corporate governance at such enterprises can be inadequate.
"Complex corporate structures and unreliable accounting practices make it difficult to perform substantive analysis on some China-related companies," Standard & Poor's said last week. "On the accounting side, the problem of limited disclosure is compounded with problems of compliance."
That's not the image many investors have of the world's most dynamic economy. Its 9 percent growth rate and rapidly growing influence in global affairs have convinced the worldliest of executives and investors that China is a risk they can't afford to bypass.
China is the national equivalent of Internet companies during the late 1990s. Investors and corporate executives seem to have little time for a discussion of the risks. 'China.com' is Asia's New Economy and anyone who doesn't see that is a fool.
The Chinese boom may be prompting a sequel to the "Jeff Vinik Effect" that pervaded stock markets in the 1990s. Vinik used to manage Fidelity Investments' flagship Magellan Fund. He grew bearish on technology stocks in 1995 and loaded up on bonds.
The bond market soured, technology shares boomed and Vinik resigned in May 1996 as Magellan's performance plummeted.
The episode became all too common during the Internet boom. At the time, even Warren Buffett was being dismissed as a dinosaur for saying he didn't understand dot-coms and their creative accounting. Skeptical fund managers held their noses and bought shares in dodgy companies.
It's hard to ignore China's potential. That is why everyone from executives at Wal-Mart Stores to the smallest venture capital firm in Silicon Valley is spending more time in there nowadays.
Yet, its equity markets are a work in progress. Its bourses are fragmented, at times illiquid and vulnerable to speculative mania. There's also little correlation with China's growth rates and the performance of equity markets. And corporate governance can be a contradiction in terms.
Hence, many people invest in Chinese companies through the markets of third countries. Institutional investors are now painfully aware that the strategy doesn't always work. China Aviation Oil disclosed its trading losses a month after its state-owned parent - China Aviation Oil Holding - sold 196 million Singapore dollars, or $119 million, shares to investors. Buyers included Temasek Holdings, Singapore's state-owned investment company.
Judging from China Aviation Oil's stock, investors had few questions with management. Shares more that tripled between December 2001 and late November when it announced its trading losses. Company officials knew of their losses last month when predicting that profit this year would outpace last year's results, the Financial Times reported. All of this surely sounds Enron-esque.

Temasek and China Aviation Oil's parent company are now being asked for a $50 million handout. If Temasek does contribute, that may have more to do with improving ties with China than with economics. Temasek, after all, could lose even more if the company fails. And Singapore has much riding on its relationship with China; trade between the countries grew more than 30 percent in 2003.
The last thing China wants to see is a globally-known company that supplies a third of its jet fuel and that is listed overseas, go bust.
Whatever the company's fate, though, the China Aviation Oil scandal is a wake-up call for those who think Chinese growth is risk-free, and for those who thought investing in other countries' markets would shield them from ugly surprises. If more abuses are unearthed, investors could be in for a rude awakening.

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