Highlights from the last week of China business news.

Hobnobbing in Bali and Beijing
Lots of high-powered meetings recently, with the attendant speculation about their outcomes. Probably the most enjoyable one to be at is in Bali, where 190 countries have sent delegates to hash out a plan - for two weeks - to replace the Kyoto Protocol, which expires in 2012. That meet started Monday, and, although details are still surprisingly thin on the ground, it appears that China will continue to reject imposed emissions targets. It will propose the creation of an international technology transfer fund - paid for by developed countries - that will help developing nations research and create their own clean technology. This works out very well for China, clearly. In the less salubrious environs of Beijing, another meeting of consequence ended this week, confirming the rumors that the top national leadership has decided to step up monetary tightening measures next year. The seasoned decoders of bureaucrat-speak at the Journal say officials now speak of a “tight” monetary policy for next year, instead of the “stable-to-tight” regime now in place. Next week, the US-China Strategic Economic Dialog happens for the last time this year. Hank Paulson flies in with Susan Schwab, product safety chief Mike Leavitt and others to talk about product safety and - surprise! - letting the yuan appreciate more quickly. Vice Premier Wu Yi must be glad she’s retiring in March.

Rio Tinto mines a rich vein of rumors
Will they or won’t they, steel executives wondered this week about a Chinese counter-bid for Rio Tinto. Last week, we wrote that China Investment Corp was rumored to be putting together a deal to buy into Rio, but that was quickly squashed by CIC and Rio executives. The sovereign wealth fund did say, after all, that it’s not confident enough to go raiding abroad yet, and that it would steer clear of sensitive industries. So the rumor mill promptly put new hearsay into circulation. For awhile, it seemed that Baosteel would spearhead a consortium of Chinese firms to snatch up Rio Tinto. A Baosteel executive told Economic Observer last week that his firm would only join a bid if the Chinese government wanted it to - hinting that a bid was possible, though not confirmed. Then the 21st Century Business Herald said Baosteel chairman Xu Lejiang confirmed that a bid was in the works. Shares of Rio Tinto jumped. Today, the official Shanghai Securities News quoted Xu denying the quote. “I did not say this. It is a fabrication of the media,” he said. Even with that seemingly definitive response to the matter, our guess is the rumor mill still has plenty of grist to keep it churning.

You can also get the weekly news by e-mail. Just subscribe here.

China is intent on keeping its markets under control. In a couple of simultaneous events Thursday, Beijing underlined a ban on personal loans to buy stocks and state media aired an interview with a well known investor who said the market is approaching a bubble.

As expected, the markets went tumbling down. Shanghai slid, breaking a week-long bull run, while Shenzhen and Hong Kong also dropped. (By midday on Friday the Hang Seng Index was down more than 400 points, negating hard-earned gains throughout the week.)

Still, it will take more than a couple of announcements to break the fevered pitch. In Shanghai, people are lining up to buy shares, now confident in local markets following years of disappointment. In Hong Kong, as capitalist a city as there ever was, investors are as willing to dip a toe in as they always have been.

The pitch hit me in the face when I walked into a branch of the smallish Wing Lung bank in downtown Hong Kong. Few foreigners use their services, as evidenced by the literature in Chinese and lackluster customer service. What was unique was the open area in the back of the branch under a sign “securities services”.

The square space was lined by five computers that displayed stock quotes. Groups or six or seven people crowded each machine, cheering stocks up or down much like one would cheer a horse at the track.

Judging by the state of the market at closing time on Thursday (the Hang Seng went up and down to close in negative territory), the cheering did little. But the ultimate reality of feverish investment is hard to ignore.

Have you heard enough on the RMB revaluation debate? Well what do you know about the QQ revaluation debate?

Actually, there is no such debate, but there is a thread of concern running through the PBOC about this QQ stuff - what is it? QQ is a virtual currency - it exists only online, but it has a value in the real world: roughly 1 QQ = 1 RMB.

This from the Asia Times, via China Net Investor:

The so-called “QQ” coin - issued by Tencent, China’s largest instant-messaging service provider - has become so popular that the country’s central bank is worried that it could affect the value of the yuan. Li Chao, spokesman and director of the General Office of the People’s Bank of China (PBOC), has expressed his concern in the Chinese media and announced that the central bank will draft regulations next year governing virtual transactions.

Public prosecutor Yang Tao issued this warning: “The QQ coin is challenging the status of the renminbi [yuan] as the only legitimate currency in China.”

Some of us may recognize QQ as the popular Chinese instant-messaging software. I had no idea they have some kind of currency, which was created to facilitate legitimate online business transactions but has since moved into gambling … and perhaps e-prostitution? The article says that QQ coins to pay for “QQ girls” in “private chats”.

I wonder if Hank Paulson is going to bring this up in Beijing this week?

I did the rounds of a bunch of domestic fund managers and analysts yesterday and they all agreed that when it comes to a safe, long-term bet on China’s stock markets that there are really only about five companies worth investing in.

Naturally they all had distinct strategies for short-term gains, eyeing different sectors and stock cycles, but they all came up with an identical five safehouses for money. There are no prizes for matching their picks because they are probably pretty obvious to most China watchers; the trick is simply knowing when the time is right to buy into them.

For some, it’s best to get in now. For others, a slight correction in the near future could see a short but modest decline in the price of entry.

But for a real safe bet, you can’t go past keeping your money in the bank; all believed the veracity of a current rumor that the RMB will be allowed to appreciate 5% against the greenback over the next 12 months. Some read it as “by at least 5%”, others as “by up to 5%”, but they were all convinced the pace of change would accelerate.

China’s willingness to let the RMB appreciate seems to be inversely proportional to the ferocity of calls from abroad for revaluation. New US Treasury Secretary Hank Paulson understands this well, and has given China room to preserve face and enact reform at its own pace.

Paulson’s strategy appears to be working. As long as the newly Democrat-controlled US House of Representatives doesn’t rock the boat in the near future, I will bypass the markets and keep my RMB in the bank.

There are heftier gains to be had, but as an unwilling holder of offshore debt, that 5% means more money for my bank.

The dollar is plummeting, other currencies including the Euro and the yen are surging. One of the reasons was a comment from the governor of the Chinese central bank. How times change. China is currently said to be reconsidering its dollar holdings versus shifting portions of its foreign exchange reserves into other currencies. Carl Weinberg, whose High-frequency Economics is one of my must-reads, is skeptical of this view, which means we must be cautious. But the forex volatility raises for me the question of when the RMB will become a reserve currency. It will surely happen one day, and China can only gain from other countries investing in its currency. But that can only happen, of course, after China makes its currency freely convertible. It is time.

The People’s Bank of China raised the reserve requirement ratio for commercial banks 50 basis points Friday to 9%, effective from November 15, the third such hike this year.

The news has been viewed as another step in the central bank’s war to peg back economic growth, which scorched across the financial world’s consciousness at 11.3% in the second quarter, the fastest in over a decade, before pulling back slightly in the third quarter. The theory goes that by reducing the amount banks can lend, the move will peg back fixed asset investment which, alongside the surging trade surplus, is held to be primarily responsible for the booming economy.

But as JP Morgan pointed out in a research note over the weekend, the move will have little, if any, effect on bank lending. The gist of the argument follows:

“As we have noted earlier, the central bank’s RRR rate hikes so far this year has not really led to significant tightening in overall monetary conditions yet. Indeed, excess reserves of all financial institutions still stood at 2.52% at the end of September, though it did come off from 4.17% by December 2005. In effect, banks seem to have been cutting back the excess reserves to fulfill the 1% increase in reserve requirements (50bp hike effective in July and August respectively). Thus, by hiking the official RRR further, the central bank aims to further “lock in” the excess liquidity at the commercial banks, rather than leaving the room for such excess reserves to be leaked back to the market/economy at any time. In short, only when the official RRR rises towards 10%, as we expect, will further adjustments in the RRR become “effective binding constraints” on overall liquidity conditions in the banking system.”

So, because banks already have greater reserve positions than required, the hike will have no impact. And even if it did, would it really slow the economy? Probably not by much. Although it is true that new loans are well above government targets, it is also true that bank lending has very little to do with the spiralling investment situation, with the bulk of fixed asset investment growth driven by retained earnings rather than bank credit. Therefore, even if bank lending were a more significant factor in booming fixed asset investment and growth, the move would have no impact.

So why do it? According to JP Morgan, the latest decision is part of a move to normalize overall monetary conditions rather than “excessively tighten the monetary environment”.

As the PBOC pointed out in its press report, overall liquidity in the banking system is still moving in the wrong direction due to sustained balance of payments surplus. This puts pressure on the banks to increase their lending to stay in the black, adding slightly to investment and growth pressures but considerably raising the spectre of more bad loans to come (does anybody remember bad loans?).

This, and not fixed asset investment, is surely the real concern for Beijing, particularly as the banking sector prepares to open fully to foreign entrants.

Henry Paulson’s speech on the eve of his departure to the G7 Summit in Singapore should be compulsory reading for anyone interested in China’s growing role in the world economy.

Unlike previous bluster from the Treasury throne, Paulson takes the tone of a concerned parent. Yes, China is still growing, but it is old enough and big enough now to take responsibility for its actions. Those actions do affect the wider economy, and it is no longer immune from the repercussions of its actions.

Discarding the usual aggressive “revalue or face a backlash” stance of his predecessors, Paulson displays a nuanced understanding of the China miracle and, more importantly, the challenges that remain.

Sure China is now big and powerful, but it is also incredibly fragile. Its financial system is a mess, failing to fulfill its basic function of distributing savings to the most productive economic players, its social safety net is stretched so thin that Chinese consumers are scared to shop, undermining efforts to introduce balance to the country’s investment- and export- led growth trajectory, and its massive trade surplus is something the other kids in the playground are obviously not going to take lying down for long.

Where Paulson diverges from his predecessors - and the current China hawks filling up the airwaves with threats and ultimatums - is that he has dropped the “reform or we will launch a backlash” line and replaced it with “reform or we won’t be able to prevent a backlash” argument.

As Paulson knows, a protectionist backlash against China will benefit no-one. He also knows that a rapid appreciation of China’s currency will benefit no-one. The solution to the undeniable problems besetting China are much more subtle. But they are tied to reform, liberalization and a market-based exchange rate.

But China also knows this. Gentle reminders to take off the training wheels are the best way to encourage China to take the right path to reform. Who knows what path China will veer down if they are removed by force or threat.

What is it about the People’s Bank of China and the number 27? I’ve been wondering for a while now why the central bank hiked interest rates twice this year, and both times settled for a 27 basis points rise. Today, researching a story on informal lending, I came across another 27 point hike, this time on October 28, 2004.

Maybe it’s a PR thing. Anything less than 25 basis points will be reported - possibly in a disparaging tone - as less than a quarter of a percentage point, which is hardly taking a hard line on a run-away economy. A quarter of a percentage point is simply to bland, while a 26 basis points increase runs the risk of being reported as a quarter anyway. Perhaps 27 is just the first reputable cab off the rank.

But it is also the product of 3 times 9, and 9 is the ultimate Chinese lucky number.

Third time lucky, good PR, or perhaps just a case of wishful thinking? Any insights appreciated.

Much has been made of the central bank’s decision last Friday to raise benchmark one-year deposit and lending rates by 27 basis points, with almost all analysts taken by surprise.

Even the Sino-foreign investment banking joint venture China International Capital Corporation (CICC) – apologies to Morgan Stanley which is more foreign than it is joint venture in the relationship these days - which could be expected to have an inside line somewhere to the central bank got caught out, arguing in an August 17 report that there was unlikely to be further tightening this year. Others, like Deutsch Bank’s Jun Ma, have recovered their poise and said they saw it coming, but just not so soon.

This writer was lucky enough to have time to retract and alter an article due to appear in September’s CER arguing no further rate hikes would be seen, with the bank more likely to drain liquidity from the system by reserve ratio hikes than attempt to use rates to peg back demand.

However, re-writing my story didn’t change my central argument, which made me realize that in China, the price of money is almost irrelevant. The banking system is not fully functioning and the interest rate transmission mechanism is, to put it bluntly, buggered. In short, rate hikes just don’t matter.

Which is just as well. In a functioning market economy, increasing rates has the effect of slowing an economy. Given China’s efforts to boost domestic spending, this could simply put the cosh on slowly improving import figures, blowing out the trade surplus further and accelerating the inflow of foreign exchange. With sterilization measures already fully stretched, that will mean more money in the system.

Luckily, China doesn’t work like that. What is important is the supply of money, and China already has too much spare cash floating around in the system. Administrative fiat is about the only way to clamp down on this, although the introduction of dividend payments would be a useful way of diverting retained earnings from fixed-asset investment, redistributing it into public spending in areas like health and education.

By increasing the safety net for China’s 800-odd million rural poor, the flow on effect will be a boost to private consumption as until-now scared-to-shop Chinese find the consumer at their recently communist-heart.

Anywhere you turn these contradictions exist, and China’s central bankers have a fine line to walk if they hope to rebalance the economy. But in doing so, they cannot afford a slowdown, which raises the fears, and the ire, of those predicting impending asset bubbles and an inflationary backlash, among a wealth of other macro-fiascos.

With a modest rate hike, the central bank gets the best of both worlds. First it appeases the macro-hawks calling for action, while sleeping soundly at night in the knowledge that the rate hike doesn’t really matter a damn.

All the hike really does is highlight the PR in the PRC.

Anyone who still believes that the revaluation of the yuan is the magic bullet that is going to save US manufaturing needs to read this trade briefing paper from the Cato Institute, a libertarian thinktank in Washington, DC. In it, the case against Senator Chuck Schumer’s proposed punitive tariffs against China is laid out carefully and thoughtfully. Some highlights:

• Imports from China are not the primary cause of the decline in US manufacturing jobs since 2000. The real reasons for the loss of some 3 million such jobs during this time were the US recession of 2001, sluggish demand abroad for US exports, and especially increased productivity in US manufacturing.
• 60% of China’s exports are made in foreign-owned plants, and much of the increase in Chinese exports has come as a result of other Asian countries sending their products to China to be “finished” before being exported to America and Europe. As Chinese exports to the US have gone up, those from other East Asian countries have gone down as a percentage of all US imports.
• Tariffs on Chinese exports would do great harm to American consumers, whose access to low-cost Chinese-made textiles and shoes, home appliances and furniture, computers, electronics, toys, and other goods greatly increases their real wages by stretching the value of their paychecks.
• Since 2001, the euro has appreciated by one third against the dollar, yet the US trade deficit with the euro zone has increased by 69%, suggesting that RMB revaluation would do nothing to lower the US trade deficit with China.

Most importantly, the paper argues, “sanctions of the kind being contemplated in Congress would also violate the same set of international trade rules that members of Congress accuse China of violating”, and furthermore, they would invite retaliatory measures from China. Do we really need a trade war between two of the biggest and most dynamic economies in the world?