The chef on the Titanic is said to have survived the icy waters by thinning his blood with booze as the band played on. China’s approach to the global financial crisis followed a similar strategy.
In the fall of 2008—with Lehman Brothers’ collapse curtailing China’s access to trade finance, capital flowing out of the economy and final demand for Chinese goods in advanced economies plummeting—policy makers popped the cork. The People’s Bank of China (PBoC) got the party started by cutting interest rates by 216 bps from August 2008 through the end of the year. Quick to don its own party hat, the Politburo in November 2008 directed the government to launch a RMB4 trillion fiscal stimulus. When policy makers gathered for the Central Economic Work Conference in December 2008, they joined the party by imposing a minimum for new loans instead of the usual limits on bank lending. Some local governments may have overestimated their tolerance: Borrowing through urban investment and development corporations (UDICs) jumped 70% to RMB7.4 trillion in 2009. Just as several stiff drinks may have saved the Titanic’s chef, China’s economy survived the global financial crisis thanks to a liquidity chug. The current economic hangover—slower growth, higher inflation, bubbly asset markets, a weakened banking sector and a bloated industrial sector—may be a small price to pay.
With the output gap closed and monetary conditions hardly tighter, consumers are beginning to feel the post-party pain. In the second half of 2010, just as the PBoC was shouting last call, the Fed decided to buy at least one more round of liquidity for the U.S. economy—and in so doing opened the floodgates for hot money inflows to China.
With consumer prices rising rapidly, China’s policy makers have begun to seek remedies. In “The Hangover: China Considers Policy Pills,”available exclusively to clients, we survey China’s medicine cabinet for hangover cures, judge their effectiveness, consider potential side effects and sketch out our baseline forecast for China’s monetary policy in 2011. Hiking the required reserve ratio (RRR) for banks has been the easiest pill to swallow, so in the fourth quarter the PBoC took three doses in five weeks, along with hiking interest rates twice. Needing more sugar to get currency appreciation to go down, the Politburo so far has used this sparingly. It also has tried other remedies—from price controls to tighter capital account restrictions—in small doses. Some policy makers are calling for a hair-of-the-dog response: The rumored lending cap for the banking sector has steadily increased from RMB5 trillion a few months ago to a minimum of RMB7 trillion today.
We expect China to employ a mix of remedies in 2011, with limited effect at easing consumer prices. Three interest rate increases after the hike on December 25 will leave real deposit rates negative for most of 2011, which will require additional macroprudential measures to prevent a further increase in property prices. A modest slowdown in growth, as we forecast in our recently published 2011 Outlook, is a likely side effect. Some of the interest rate hikes in 2011 probably will be asymmetrical to increase the role of price signals in credit decisions. This will be a gradual process, however, since moving too fast to remove the subsidized net-interest margin of the state-owned banking sector would put it at risk of insolvency.
The PBoC will allow the RMB to appreciate modestly, creating a need for additional RRR hikes and stricter enforcement of capital controls to deal with increased hot money inflows. As RRRs reach their limit, the PBoC will have to return to open-market operations, which will require higher yields on the bonds it issues. This, in turn, will limit RMB appreciation, as it will raise the funding costs for the PBoC’s sterilization efforts. The RMB will also see more internationalization, though not enough to cause lending quotas to lose their bite.
Finally, the government will not exhibit much of a fiscal impulse in 2011, but it will not consolidate its balance sheet much either, for fear of drifting from its longer-term target of rebalancing the economy toward domestic consumption.
Though Chinese policy makers will spend most of 2011 cleaning up after the party, all the while they will be laying the foundation for financial reforms that will lead to increased use of price controls in lending decisions, further internationalization of the RMB and eventually the opening of the capital account.