‘Yuan revaluation the only cure for China’s problem’

Michael Pettis, a professor at Peking University’s Guanghua School of Management and a specialist in Chinese financial markets, is the author of, among other books, The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). In a telephone interview from Beijing to DNA Money’s Venkatesan Vembu, Pettis explains the risks that rising hot money inflows and an excessively loose monetary policy pose to China’s financial system and the management of its macroeconomy. Excerpts:

How much hot money is coming into China?
It’s very difficult to come up with an estimate of hot money inflows because there isn’t even a definition of what hot money is. All we can do is develop rough proxies-starting from the headline foreign exchange reserves numbers and working your way through-that give us a sense of the scale and direction of the change. And when we do that, what we end up with is unexplained amounts that have always been relatively high, but have mushroomed in the last few quarters

You’ve arrived at a figure of $257 billion in terms of “unexplained inflows” in just the first five months of 2008
That’s right, about $250 billion in “unexplained inflows” for the first five months of 2008, but not all of that may be hot money.

When you’re looking at hot money, you’re not looking at absolute numbers, you’re looking at the trend in your proxy. And if your proxy shoots up and you can’t find a legitimate explanation for it to shoot up, the assumption is that the hot money has probably shot up

Is there any parallel in developing economies for this level of hot money inflow? That’s one of the things that people are not focussing on enough. Only two years ago, when China’s foreign exchange reserves went up by $247 billion, it was the biggest one-year increase in reserves in the history of the world!

This year, China’s reserves are going up at the rate of $1 trillion; just the total amount of hot money coming into China this year is probably going to be significantly bigger than the biggest one-year increase in reserves in the history of the world until 2006.

These numbers are just huge; we have no experience with them, so it’s very hard to figure out the likely consequences.

But the big story is that China’s rapid growth in reserves, which has accelerated, is now being driven by something that is a lot less stable than the trade surplus and FDI, which is hot money flows.  

What are the channels for these hot money inflows?
It’s coming in not necessarily in large blocks of money, but through a thousand different points, and in millions of small transactions...

China has three things that militate against its ability to control capital flows. First, it has long trading borders, and countries with long trading borders have a great difficulty in controlling capital flows. India has the same problem. There are just too many places that money can come in and go out. Second, China has a long history of capital controls-and, paradoxically, the longer you have capital controls in place, the more likely they are to be eroded.

What are the risks of this money floating around?
There are three things to worry about:
Overinvestment and overproduction: Chinese companies have too easy access to capital-at negative cost (less than inflation) -so the tendency is to just build more factories.

As long as the world is willing to absorb all of this Chinese production, it’s not a problem, but if there’s a slowdown in the global economy, we’ll see a rapid build-up of inventory until at some point companies start cutting down production.

Second problem with loose money everywhere-and we’re now seeing it with the sub-prime crisis in the US-is that in every single case in financial history, periods of excessive loose monetary policy have led to excessive risk-taking in the financial system. And you don’t find that out until the contraction. In Warren Buffett’s famous phrase, until the tide goes out, you don’t know who’s swimming naked. We know there’s a lot of garbage out there, but we won’t know it until there’s a contraction.

The third obvious problem is inflation

What are the risks to the banking sector?
A huge risk. You won’t know how bad it is until the contraction, and you can discount 100% whatever you hear about reserves being built up, NPL ratios going down... You can forget about all that because it’s completely irrelevant. We won’t know until it’s been tested.

What has the Chinese government done to choke off hot money flows? And how effective have their measures been?
There seems to be an internal debate between those that are more concerned about an economic slowdown and those that are more concerned about monetary excess, but it isn’t clear that that debate has been resolved. 

What is the biggest macreoeconomic risk to China if it persists with its monetary excess policy? How bad can it get?
I think what’s likely to happen is that we’ll see inflation in the double digits. Once you start off that inflation process, and it gets out of control, it’s going to take a sharp contraction to break it.

What does the Chinese government really need to do? 
They need to reduce money inflows into the country. The only way they can do that is by addressing the currency directly. And the only solution for addressing the currency is going to be a one-off revaluation.

By how much?
I would say 15-20%

What else do they need to do?
The currency has to go up. It will either go up in the form of a maxi revaluation or in the form of runaway inflation. That’s the choice.