Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Print Print Cite Cite
Style: MLA APA Chicago Close


Waiting for the Plenum

by Brad Setser
September 29, 2007

Michael Pettis

It is hard to overestimate the importance to China's near-term and longer-term prospects of the 17th Plenum in two weeks.  These meetings, held every five years, are the main events of China’s political cycles and it is during these meetings that the big promotions to senior positions within the Party and, juiciest of all, membership in the Standing Committee of the Politburo are made.  The Standing Committee consists of the nine men (previously seven, and there are not completely credible rumors that it may be reduced to seven again – the decision has everything to do with factional fighting) who are the ultimate source of power in China today, and is headed by President Hu Jintao and Prime Minister Wen Jiabao. 

Although the deliberations are secret, the months leading to the congress are rife with factional infighting, sweetheart deals, attacks on frontrunners, corruption scandals, and the all-important maneuvering for promotion.  Unfortunately, on the assumption that that any serious contender must at all costs avoid doing anything that may give rise to criticism before the promotions are decided, the period before the meetings tends to be a time in which very little, no matter how urgent, gets done.  For this reason, although the government is watching with terror China's rising inflation, after the last interest rate move little has been done except to freeze a number of prices, and this latter is rumored to have been done almost solely to prevent rising prices from ruining the feel-good ambience that is always required to permeate the national congress meetings.

Once the congress is over – we expect that to occur around October 22 or shortly thereafter. – the financial authorities have some very serious problems to deal with.  Logan Wright, a Beijing-based analyst who regularly writes excellent reports on China’s financial system for Stone & McCarthy, puts it this way in a September 27 report called “China's Perfect Storm? Food Price Inflation and a Possible PBOC Policy Shock:” 

First, at the same time that pork prices have driven August CPI growth to 6.5%, China has also been ravaged by unusually harsh floods in the south and droughts in the north. As a result, the autumn harvest, which comprises around 70% of total annual grain output, could produce a significant negative surprise, accelerating the rapid rise in food prices. At the same time, global food prices and futures continue to trend higher based on a series of bad harvests around the world, just as China may need to increase imports to supplement its own supplies. Secondly, signs of weakness in the housing sector spilling over into U.S. consumption are developing, and this could have consequences for China's exports, which have been a critical engine of China's growth and a safety valve for domestic overcapacity in several industries. Third, and perhaps most significantly, inflation is more salient politically in China than in other nations, because of its tendency to produce social unrest that challenges the legitimacy of the Chinese Communist Party's rule. Support for the CCP depends heavily upon improving standards of living for Chinese citizens. This means that the Chinese government is very likely to react quickly and strongly in response to a potential threat of escalating inflation. 

I think that one very important change that has happened this year is the very belated recognition, beginning all the way from the top with Wen Jiabao (about whom, unfortunately in my opinion, there are lots of rumors about his wanting to retire), that the arguments about excess monetary expansion and overheating are no longer widely resisted.  It has taken far too long, but I think that the leadership has finally recognized how out-of-control China's monetary and trade policies have been and how dangerous the next few years will be.  In spite of this recognition, there has been precious little done to address the root causes of the imbalance, and I would guess that an important part of the reason has been the reluctance politicians have always had to taking tough measures during promotion time.  Whatever the risks, it is still safer to do nothing now, and pray, then to take the kind of actions that will be needed to address the overheating problem. 

After the meeting, my guess is that we are going to see an acceleration of programs and proposals to slow the economy down, although the fear of creating problems before the Olympics may continue to slow down the process of reform.  What will they do?  I have always believed that the currency regime is at the heart of China’s trouble, and as long as the leadership fails to see this and change the currency regime directly, I am afraid the measures they impose will be more of the same ineffective measures – interest rate changes, administrative measures, etc. – the have failed to slow things down during the past three years. 

I am not enough of a political insider to say what is likely to happen and who will drive policy over the next few years, but there are two individuals who are rumored to be among the candidates being considered for the Standing Committee whose promotion may give some indication of where things are likely to go.  Bo Xilai, the current Trade Minister, has a great reputation for his grasp of economics, his openness to the rest of the world, and his understanding of monetary policy.  Zhou Xiaochuan, the Governor of the People’s Bank of China, is another extremely strong and very smart candidate who is rumored to have been among the most vocal supporters of a faster RMB appreciation.  Generally speaking I don’t think many of the current leaders – whose backgrounds are predominantly in engineering and who are not particularly well-known for their imaginative approaches to new problems – have been able to understand how imbalances are being built up within the economy and banking system, and it is good that so many of the rumored “promotees” are supposed to have stronger backgrounds in economics. 

If either of Bo or Zhou are promoted onto the Standing Committee, I think we may end up seeing smarter and more preemptive activity in dealing with China’s monetary imbalance.  If inflation figures for September and October stay above 5% or even accelerate I think we may see an acceleration of RMB appreciation even earlier than expected.  This is all speculation, but like a lot of people in China I will be following the congress rumor mill very closely.


  • Posted by Dave Chiang

    Personally, I don’t believe the China PBoC will accelerate the current rate of currency appreciation versus a basket of currencies since millions of workers remain employed in the labor-intensive textile industry. It would be very destabilizing to rapidly revalue the Chinese currency leading to mass unemployment and potential political instability. Western Neo-liberal economists shouldn’t get their hopes up too high, the Chinese PBoC isn’t going to solve America’s global competitiveness problem by agreeing to a massive China currency revaluation. Instead, the Chinese leadership is likely to liberalize capital outflows allowing private investment in overseas equities especially for Hong Kong. Given the Bush Administration’s oil grab strategy in Iraq, further Chinese strategic investment into Africa, Central Asia, and Latin America resource sectors can also be expected. The protectionist US Congress blocked state-owned China CNOOC from the Unocal acquisition, but what happens in the future if Chinese private sector mutual funds buy a majority holding stake in Cisco, General Electric, Intel, IBM, Microsoft, etc. China’s privately held Huawei acquisition of 3COM corporation this week is a prelude to what is to come around the world.

  • Posted by Anonymous

    does Dave Chiang work for the PRC gov?

  • Posted by qingdao

    Excellent post as usual, michael; I hope you keep it up; unfortunately, neither of the worthy individuals you mention will make the cut; like most Westerners, you are not as yet sufficiently cynical; but I hope I am wrong.

  • Posted by Alex Forshaw

    Anonymous: you’d better hope not, but I doubt it considering that his pinyin-ized last name (“Chiang”) is a traditional transliteration, not a PRC “simplified” one (that would be “qiang” or “jiang,” I think), which means he’s probably from Singapore, HK, Taiwan, or Taiwanese parents in the US.

    Dave: If a country gets competitive because it has a controlled currency, then that country is the one with a competitiveness problem – not the United States.

    There has been huge asset flow from savings deposits to the Chinese stock market, probably in reaction to skyrocketing domestic inflation/negative real interest raets more than anything else. A huge amount of the Chinese FX reserve is probably effectively claimed by the banking system, because banks have been under significant pressure for a while as savers have withdrawn deposits and thrown them at the stock-market slot machine.

    There isn’t going to be a worldwide acquisition spree by the Chinese SWF on the scale that many expect. And if there is, that’s awesome news, because it will play out in the same way as the Japanese acquisition spree did in the late 1980’s (and the Chinese Blackstone flop over the summer).

  • Posted by AF

    Also, I definitely agree with qingdao’s cynicism.. Chinese policy is overwhelmingly about short term politics. Even if the two currency hawks mentioned keep their heads down, all the interests that depend on China’s Argentine monetary policy still have a very good idea of what the hawks’ policy inclinations will be, so they will keep the hawks out, and the runaway train will fly off the tracks a day after the Olympics instead of a little bit before.

    In the parts of China where Chinese growth stats even somewhat correlate with reality, inflation is almost certainly higher than the PRC admits, and the PRC knows it, imo.

  • Posted by Guest

    Maybe China wil buy grain and pork instead of treasuries and agencies

  • Posted by Guest

    China over the last few years has been ruled by two factions. One is the coastal faction, and the other is the populist factions, and the new Standing Committee is likely to be balance between these two factions.

    It is true that the populist faction doesn’t have a deep grasp of monetary policy and foreign trade, but on the other than the “coastal faction” doesn’t have a good grasp of rural administration and agricultural policy. The nice thing is that these two groups are not in a “zero-sum” situation and they have been able to work with each other quite well.

    Chinese policy is *not* about short-term politics (well at least not more than other places). The thing that drives everything is the long term desire to keep the party in power. It’s totally unthinkable to me that the PRC leadership is going to wait until after the Olympics to do anything, because they will still be around when that happens.

  • Posted by Twofish

    That previous post was from me….

    Also I think it has taken so long because it’s only in the last two months do you have enough data that something is definitely wrong with PRC currency policy to convince the skeptics.

  • Posted by Dave Chiang

    Alex Forshaw,

    America’s Global competitiveness problem isn’t the responsiblity of the Chinese to solve. Period.

    From this week’s Newsweek magazine,

    The global economic turbulence isn’t emanating from the East, as it did during the Asian financial crisis 10 years ago, but from the West. “This time around, the financial indiscipline and lack of respect for risk is not coming from inexperienced emerging institutions, but so-called experienced institutions losing their head,” says van Agtmael. “The overborrowing, overconsuming and underinvestment is now in the U.S., while emerging markets are accumulating reserves, building their infrastructure and, to some extent, bailing the world economy out because of their strong demand growth.”

    Americans are annoyed as hell at the Chinese. The U.S. Congress thinks it knows how. Citing hazy national-security concerns, Washington’s lawmakers barred China from taking over Unocal, a California oil company, in 2005 and last year forced Dubai port operator DP World to sell its U.S. operations. More recently, there’s been political grousing over Borse Dubai’s bid for 20 percent of NASDAQ. But it’s unlikely that protectionism will stem the tide of suitors.

  • Posted by Anonymous ibid.

    Dave, inflation in foodstuffs creates what is euphemistically called “political risk.”

    I would be very surprised if China does not revalue, not for the sake of the West, but because it is in its own national interest.

    The problems of the US are relatively easy, as least in principle, to solve. Defense and healthcare spending are too high. Taxation of the upper 0.1% is too low, as is investment in technology and infrastructure. Some industries need de-consolidation. Elections need to be cleaned up.

    All of these are, in principle, much easier to resolve than the challenges China faces. The political leadership of both nations is, in my quiet opinion, very similar, with the single exception that the Chinese leadership has not yet been in a position to behave openly with the hubris that the American leadership has.

    That time may come, too. The only difference, after all, is behavior vs. attitude.

  • Posted by Twofish

    The primary responsibility of the Chinese government is to look after the national interest of China and the primary responsibility of the US government is to look after the national interest of the United States. However, technology has reached the point that national interests are now intertwined. It is now impossible for the Chinese economy to sink without sinking the US economy and vice versa.

    So it is in people’s self-interest for China to do anything it can to help the US economy, and for the US can do anything it can to help the Chinese economy.

    About CNOOC and Dubai ports. National security was just a smokescreen and wasn’t the real issue. Money was. Chervon wanted to win the Unocal deal so they pulled out all of the public relations people, talked about national security, and managed to give a microphone to people that are normally ignored. (US China Security Review Commission, I’m talking about you……..)

    That’s how the game is played. CNOOC made some strategic mistakes, due to a lack of understanding about the US business environment. It should have gotten its public relations, lobbyists, and media consultants ready at the start of the game.

    Also, CNOOC was operating at the limits of its cash flow. (Contrary to what you hear in the media, the Chinese government doesn’t give subsidies to SOE’s for overseas accquistions). Also, CNOOC was slow out of the starting gate because the CEO had to convince the board of directors that the deal was a good idea, and Chinese CEO’s weren’t used to deal with active boards. Finally, it’s not clear to me whether the deal was in CNOOC’s interests or in the interests of the Chinese state or the Chinese people who were CNOOC’s majority shareholders. There is a fundamental conflict of interest between the management of the company who tend to want to build financial empires, and the shareholders who find these empires costly.

    If you want to do business in the United States, the most important things are to have good “guanxi” (connections) and to understand and respect the local culture.

    Finally, there really wasn’t much support I could see within the Chinese government for CNOOC’s takeover of Unocal. The PRC has $1 trillion in foreign exchange reserves. It could have easily written CNOOC a big check. It didn’t. The concern of the Communist Party was that once a rich uncle writes a big check for one of his nephews, all of his other nephews are going to come in line for their checks. Things like the China Investment Corporation are intended to regulate this.

  • Posted by HZ

    Inflation above US level results in a real appreciation of RMB. So in a way the RMB is already appreciating faster. I hear so far inflation is limited to food (and asset price, of course, but that is not part of CPI). In the case of food, subsidizing the purchasing power of the city poors seems a better response than an overall monetary response.

  • Posted by Twofish

    The other issue is that if food prices remain permanently high after the demand shock is over, then what we have here is an effective wealth transfer from the cities to the countryside, which isn’t necessarily a bad thing from a national standpoint given that most Chinese are still farmers. The one piece of data that I’m sure the Politburo has that I don’t is how this food inflation is affecting the countryside.

  • Posted by df

    Higher food price mean higher wages. This means that finally it may be the end of a long era of falling global minimum wage.
    The coming olympic games might well get explosive. I expect them to be so. By 2008 consumption from the USA and EUrope will be down for the same reason : end of the global housing and debt bubble.
    When financial markets finally turn rational (and I know very well that markets stay irrational much longer than I or individual others can stay liquid) they will crash down to lower prie earning ratio below the long term mean. RIght now we are way above the 14 – 18 mean (depending on measures and markets) despite overstated returns. So in 2008 we should have : desappointed stock market players, workers with falling standards of living because of rising food prices and peasants hurt by weather conditions.
    In fact the really funny thing in all this is how the weather is playing its own part and adding its exogeneous woes to the already huge endogeneous ones.