Insights on the Renminbi, Hot Money Flows, and Chinese Monetary Policy for 2012: Standard Chartered's Stephen Green

Stephen Green, head of Greater China research at the multinational financial services company Standard Chartered, is one of our favorite China experts. We caught up with him earlier this year on Chinese municipal debt and inflation targets, among other things. This time we get an outlook on the renminbi, why it has been weakening compared to the dollar as of late and whether or not that weakening signifies short-term capital flows out of the currency. Green also brings us up to date on his team's expectations for Chinese fiscal and monetary policy in 2012. Partial transcript below. On the real reason behind recent weakness in CNY against USD:

Hot money is very difficult to define and even more difficult capture in data. It's possible that there is a little bit of hot money flowing in and out of China, but the main reason for the renminbi weakness at the moment is that we believe the corporate sector--all of the tens of thousands of companies that import and export stuff from China--their expectations about the renminbi's future path of appreciation have changed dramatically over the last couple of months. So, they are changing their conversion behavior. For instance, if you were an exporter, up until a few months ago you were receiving dollars and you had renminbi costs. Your renminbi was appreciating and your dollar was depreciating. Really, your big incentive was to get your dollars as quickly as you could and sell them to get renminbi as quickly as you could. You would do a forward transaction to do that even quicker because the renminbi was appreciating, and you expected it to appreciate. As soon as that expectation changes--which it has in the last couple of months--you stop doing that. You're not so keen to get rid of your dollars, and exactly the same thing on the other side--vice-versa happens to the importers. Because China does such a huge amount of trade every year--Chinese exports this year will probably be around nearly $2 trillion--any small change in the exporters' conversion behavior has a huge impact on day-to-day demand for dollars in the onshore FX market. For the note, we simply went through all the data from the corporate sector and the bank sector, looked at that conversion behavior, and we can see pretty clear evidence that actually, in the last couple of months, the corporate sector as a whole has become much less keen on selling its dollars. So, net demand for dollars in the interbank market has declined dramatically.

On how this changes the way we track FX reserve accumulation in China:

What happened before was every quarter we got China announcing its FX reserve numbers for the last three months. Then, what all us analysts would do was take that number and adjust it for the valuation effects in the FX portfolio--dollar, euro, all of those valuation effects. Then, for each month, we would take away the trade surplus in that month, we would take away FDI flows into China for that month, and we would look at payments from the US Treasury and other central banks--interest payments, coupon payments. We would take those things away from the FX number--the increase in FX reserves. The remainder many analysts would call "hot money." That was kind of the proxy for hot money either going into China or exiting China. The problem with that was that actually, the trade surplus isn't really telling you--just because China runs a $30 billion trade surplus one month, that doesn't tell you that the corporate sector is net selling $30 billion. Many of those corporates might keep those dollars. What we are doing now is looking at the actual behavior of the corporate sector--how they deal with their dollar receivables and dollar payables. That should, we hope, give us a better sense of what the real unexplained amount of money coming into and out of China is. One of the comments we've had from clients is that surely some of the stuff we're noticing through through the current account is "hot money"--maybe some of these trading firms are actually running their own trading positions alongside their trading goods and services. Because of the capital controls in China, it is very hard to get money in and out of China. If you are "hot money," if you want to get a few million dollars into China, you probably are going to use a trading firm or a firm which has an FDI project because that's the only legal way to get your funds into China. So, we're not saying that doesn't happen. We're just saying that at the moment, we think the prominent driver of renminbi weakness is decisions by firms which do real economic activities rather than hedge funds and other so-called "hot money" speculators.

On what China's reserve requirement ratio cut means for future policy:

I think it's really significant. The market was probably waiting for January before they saw a clear sign of China moving away from a tight monetary policy toward a looser monetary policy stance. When the central bank reduces their required reserves, it means that the banks have more excess reserves and overall interbank liquidity comes down, so it improves. At the same time, the banks have a little bit more free cash to lend. We think it's pretty significant. We think it's the first signal that China is moving on a policy basis to allow the banks more liquidity and to encourage the banks to lend that liquidity into the corporate sector. If there is anything we know about China's economy, it's that it is a credit-driven economy. Really, over the last year, the predominant reason that China's economy has slowed down is because they controlled the supply of credit into the economy. Of course, if you don't allow the banks to lend, other folks are going to find ways around that. We've seen a flowering of the informal credit sector--whether it's underground banks or trust companies or borrowing money from Hong Kong banks--that's clearly happened. Still, China's economy has slowed down because of tighter credit. Now, we know that there is a big debate going on in Beijing. One of the reasons we know that is because we still haven't had the Central Economic Work Meeting. Every year, usually in November, the central government, all the economic ministries in Beijing, all the provincial governors, and anyone involved in economic work come to Beijing and sit down for two days to discuss--or be told, rather--what the economic policies and objectives are for the following year. It's now the first week of December and we haven't had that meeting. That tells us that there is a big debate going on. It's probably focused on a number of things--housing policy, the real-estate market, what's going to happen in Europe--but I think a big chunk of that is what to do with monetary policy. How quickly do they ease? Do they have to do a stimulus package? If they do a stimulus package, what kind of stuff should we do? What is going to be the impact of the eurozone having even greater difficulties? I think those are the kind of questions that are really preoccupying Beijing, and I think the fact that we haven't had any meeting yet is suggesting that they really haven't agreed on any answers yet.

On specific likely policy action in 2012:

We have reserves for the big banks at 21 percent at the moment. Next year, we are looking for 200 bps in cuts to that. It could be more, but we think that is almost certain. The bigger debate among all of us economists at the moment is whether China moves to cut interest rates as well. We think no. The reason for that is because we think the economy can be stimulated quite effectively by cutting reserves and increasing the banks' loan quota. Particularly this year, we had a very tight loan quota every month. Each bank could only lend a certain amount of renminbi, a number set by the central bank. Next year, we think the loan quota is going to be bigger. In 2011, it was 7.5 trillion renminbi. Next year, we estimate it's probably going to be in the range of 8.5 to 9 trillion. So, we think that you can do those two things and that will more or less guarantee more credit coming into the economy. You don't need to cut interest rates. In fact, interest rates are actually quite low in China. Some people think that China could raise some of its interest rates next year--particularly the deposit rates, because deposit rates are still very, very low. We know the PBoC generally believes interest rates are too low for this economy. That's one of the reasons we have those housing bubbles appearing and why probably there is quite a lot of inefficient investment which goes on. I think the central bank next year, even if the economy slows down, will not be too keen on cutting interest rates. Although at the end of the day, if the economy is slowing down aggressively and we get a shock from Europe, then I imagine they probably will need to cut interest rates.

On which asset classes are positioned to benefit most from this policy outlook:

Chinese equities obviously have many, many issues. We generally think that when China moves to boost credit, that there is a reaction in the economy. So, by the second quarter of next year, we do think Chinese growth will be picking up. The next couple of months, I think we are going to see continued weakness from China's corporate sector. We think inflation is coming down, which is going to help a lot of margins--manufacturing margins. At the same time, corporate credit is going to become easier. So, around Q2, we are looking more positively at the Chinese equity universe. Obviously, equities are impacted by a whole bunch of other factors, Europe being one of them. So, it's highly dependent on stabilizing the European situation. That, we think, is one thing we are looking for. Commodities--China buys a lot of iron ore, copper, these kind of things for its industrial and infrastructure buildout. There, I think we need more clarity on exactly what the government's plans are for both the real-estate sector and for its infrastructure buildout. The real-estate sector, we think, again, the government will be moving to remove some of these restrictions by the middle of the year. Lots and lots of restrictions on who can buy a house, who can buy an apartment, who can get a loan for an apartment, how much tax you have to pay, etc. That's really cooled down the property market in China. It's going to get worse before it gets better. There is a lot of unsold stuff being built at the moment. Again, by the middle of next year, we look for a loosening of those restrictions. That will help the equity universe; it probably won't have an immediate impact on commodities demand.

On what else Green is keeping an eye on over the next year:

I think the real risk for the investment sector is the real-estate sector at the moment. The thing that slightly concerns us is that all of the measures in the last year and a half in China's real-estate market have really been short-term measures--preventing nonresidents of Shanghai from buying Shanghai apartments, and raising down payments up to 50 percent on second apartments--these kind of things. The fundamental problems of China's real estate sector--i.e., very low deposit rates for households, so they have a big incentive to invest in real estate, rather than put their money in the bank--that hasn't changed. The fact that local governments all around China still make 30 to 40 percent of their income selling land--so they have a big incentive to keep land prices, and therefore apartment prices, high--that whole fiscal part of the economy hasn't changed. Our fear is that--and maybe it won't happen next year, but it could easily happen a year or two later--when all of these restrictions are removed, you could actually see property prices move up again. Then, I think, we'd be in danger--maybe around 2014 or 2015--of having a real Chinese property bubble.

On Larry Lang's strong comments about China's debt situation and the likelihood of a "hard landing" in China:

In that speech, he said that he had done some surveys and gotten the data. I haven't seen any published data from him, so it's rather hard to judge his claims without any evidence for them. There are a lot of people who think that China could experience a hard landing, a property crash. Many of those folk have done decent research and published it, so it's easier to debate with them. I think it's well worth while to take a cold, hard look at the Chinese economy. There are serious problems with it. It's unbalanced, there is too much investment that goes on, much of that investment is inefficient, property prices are extremely high in many cities, and consumption as a percentage of GDP has not really gone up at all in the last five years. So, I think there are clearly challenges. My general take is that all of these problems don't necessarily mean a crash in the short term. I think these are more problems which would erode away from growth over a five to ten year view. The second thing is that the government has an enormous capacity to avoid a crisis at the moment. They more or less control the capital account, so they can keep money in China. Household savings rates are very high, so although you have some inefficient investment, you can afford to waste some of that capital--it doesn't have existential consequences if you do. You've still got urbanization, which is continuing to rise, where probably 50 percent of the population is urbanized. Most of Asia is 70 plus percent urbanized, so that flow into the cities continues. Productivity goes up as a result of that. If you look at China's capital stock per capita, it's less than 10 percent of the U.S. level. That means that if you wander around all of China, the quality of the infrastructure, the factories, the residential real estate--all of that stuff is at 10 percent of the U.S. level. So, things like that suggest that there is still an awful lot more of catch-up, simple catch-up, for China to grow over 5 to 10 years and narrow the gap in the quality of life of Chinese citizens from European and American citizens. So, China looks more like Japan in the early 1970s rather than Japan in the late 1990s. Of course, there are risks, and we would be stupid not to take those seriously. We also need to recognize that there are a lot of growth drivers out there, and there are a lot of mechanisms for the government to avoid a hard landing. We do hope and look for greater reforms. One of the most astute worries or criticisms about the last few years of policy in China is that there haven't really been huge reforms. The service sector remains very state-dominated, very controlled, very closed off from the private sector. The health sector still seems to be a bit of a mess, the housing market isn't really reformed, and the fiscal system has some problems as well. The private sector still suffers--the SME sector still suffers from overburdened regulation and tax burdens. What we are really looking for over the next five years is a new wave reforms in China, which would release some new growth energy. If we don't see those, I think five to ten years out, we will be looking at Chinese growth of five or six percent potential and an economy which is much more vulnerable to shocks.

On the Chinese economy's ability to withstand a bear scenario in the eurozone:

We are looking for a recession in the eurozone next year, somewhere around 1 to 1.5 percent of GDP. We think, as many people do, that the U.S. can probably grow around 2 to 3 percent. So, Chinese exports are going to be in the range of 5 percent growth next year, possibly weaker. Obviously, we're not going to see a rapid solution in Europe. We are just hoping for a big, strong band-aid, I think, in the next few weeks and months while we wait for treaty changes and some of the fiscal retrenchment and economic reform in the periphery to feed through. It is going to be tough in the next couple of years for Europe, and Europe is China's biggest export market. China is going to have to cope with that. Let's hope it's not a big shock but a mild recession. I think China could probably cope with that ok. The labor market looks kind of ok at the moment. Wages seem to be pushing up, and domestic demand is becoming a more important growth driver for China--exports are less important than they once were. The longer the European crisis remains, obviously the tougher it is for Beijing to make that transition.

Follow us: @lukelavanway @matthewboesler @benzingaradio @benzinga