Monetary conditions might exacerbate the Chinese adjustment

I think if I were an economic policymaker in China I would be spending most of my time thinking about the money supply and how it works. There is a small but growing possibility that Chinese monetary conditions are going to go wrong at exactly the wrong time, and policymakers will need to have a well-thought out and vigorous plan to address it if it happens.It has become pretty clear that the huge amount of hot money that poured into China last year and earlier this year is beginning to reverse itself pretty sharply. According to a PBoC release yesterday, China’s foreign exchange reserves increased to $1.946 trillion at the end of 2008, up from $1.906 trillion at the end of September. Here is what Logan Wright, of Stone & McCarthy, said in a release earlier today:

The Q4 2008 foreign exchange reserve data, released yesterday, indicate that China’s six-year liquidity cycle may be coming to an end, triggered by limited expectations of further yuan appreciation alongside a rapid downturn in both the domestic property market and global consumption of Chinese exports. Despite a record-high quarterly trade surplus of $114.3 billion and additional sources of capital inflow, China’s foreign exchange reserves rose by only $40.4 billion in the fourth quarter. This suggests that China saw significant levels of capital outflows during the fourth quarter, which we estimate totaled around $120-140 billion. Valuation adjustments may explain the decline in headline reserve levels in October (by $25.9 billion), but they cannot explain the entirety of the slowdown in reserve growth during the fourth quarter.

It has become harder than ever to figure out exactly what is going on with central bank reserves – and of course just when we need clarity most – so there is a lot of variation in all of our estimates about the different components of the adjustments in reserves, but Logan is one of the most careful of the PBoC watchers and his estimates on hot money outflow fall into line with my own and most of the other credible estimates I have seen. For example Mark Williams of Capital Economics said in a release yesterday that “hot outflows may have amounted to well over $100bn last quarter, equivalent to around 8% of Q4 GDP,” and Stephen Green at Standard Chartered said in another release yesterday that he calculated the “unexplained” amount of reserve changes to be about $110 billion, although at least part of that may be accounted for by a lag in trade payments.

Remember that there are two reasons for hot money to leave China – one on which most of us have focused, and another, which may be more important but which hasn’t received the attention it deserves. The first is the expected excess return for bringing money into China or taking it out – basically the RMB deposit rate plus the expected appreciation of the RMB less the equivalent US dollar deposit rate. When there were tremendous expectations for RMB appreciation, money poured into China, and now that those expectations are evaporating, or even going negative (i.e. there is some concern that the RMB may depreciate), it is likely to leave.

The second reason for hot money flows, not as widely discussed but at least as important, is the perception of risk, especially of the financial system. Remember that whether any given level of expected appreciation results in outflows or inflows depends also on the expected risk. As risk rises, it will take a lager expected return to encourage inflows. As China’s economy contracts, and as local businesses become increasingly worried about the potential for the current crisis to lead to deeper problems, including problems with the banking system, there is an increasing incentive for wealthy Chinese businessmen to take money put of the country.

For much of 2007 and early 2008 I argued that Chinese monetary policy had locked the country into a dangerously pro-cyclical trap, and unless the PBoC engineered a one-off revaluation that would stop hot money inflows, there was a real risk of incurring destabilizing capital inflows and outflows. When things were going well and the country’s economy was booming, hot money would pour into the country, unleashing a credit bubble and exacerbating the problem of overheating and overcapacity.

Once conditions turned around, however, I worried that hot money outflows would have exactly the opposite impact, causing a contraction in the money supply that would lead to credit contraction and an even sharper economic slowdown. This is always the great danger of hot money – when things are going well it pushes the economy into overheating, while squeezing the economy just as things start to get bad.

Needless to say, the PBoC did not revalue the RMB or otherwise move quickly enough to control the torrent of hot money inflow, and now they may be forced to deal with the accompanying but opposite problem. As conditions deteriorate, hot money outflows will become a real monetary drag.

This is not to say that these outflows are creating a problem for China right now. On the contrary, with outflows more or less matching current account and FDI inflows, the net impact is that for the first time in several years the PBoC finally has some apparent control over domestic monetary policy.

What worries me and some of my other PBoC-watching friends is the implication of this reversal on future monetary conditions in China. The outflows are almost certainly likely to cause contraction in credit – especially in the informal banking sector, where much of the hot money inflow may have hidden – and one can make a very plausible argument that outflows, and the attendant credit contraction, may exacerbate the slowdown in the economy.

If it does, and in so doing increases the perception of riskiness in China, it may create further strong incentives for local business owners to take money out of the country. China, in other words, has locked itself into a highly pro-cyclical monetary policy, and one of the key points to remember about highly pro-cyclical systems is that it is very hard to predict exactly where they are going, but it is a pretty safe to predict that whatever they do they will go to extremes (as if to confirm my worry about exacerbating tendencies, I see that China’s National Bureau of Statistics has just revised upward China’s sizzling 2007 growth rate of 11.9% to 13.0%).

To extend this a little further, it is worth remembering that there were at least three important factors that caused the severity of the Great Depression in the US. First, the US had to deal with a substantial industrial overcapacity problem just as the European countries that absorbed US overcapacity by running trade deficits with the US saw the financing of these deficits interrupted. I have written about this several times in the past few weeks so I won’t discuss it further.

Second, the US did not expand fiscally nearly enough to counteract the decline in domestic and foreign demand for US production. I know that this is a controversial point and I don’t want to get into a debate about the efficacy of fiscal expansion, but as I see it the US would have been better off if the government had followed Keynes’ advice and expanded more quickly. Third, the US experienced a severe monetary contraction as some banks either collapsed, others sharply contracted their lending, and depositors and businesses hoarded cash. The Fed should have accommodated this contraction by relaxing monetary conditions but failed to do so. According to Milton Friedman this may have been the single biggest cause of the severity of the contraction.

So where does that leave China? The overcapacity adjustment in China may be much larger than the one faced by the US – with 40% of global GDP the US had to absorb a trade surplus of roughly the same magnitude as China, which accounts for only 7% of global GDP. On the fiscal side I think China will definitely expand much more aggressively than the US did in the 1930s (how could it not?) but of course there are real questions about how much real expansion there is, how it is going to be financed, and how much of it will simply be wasted or turn into NPLs. Most importantly, can China expand enough to make up for the contraction in US and European demand (the two economies are more than six times the size of China)?

The US experience in the Great Depression suggests that among the things we should be most worried about in China is underlying monetary conditions. If hot money outflows accelerate and, as is likely to happen, the trade and FDI surpluses drop sharply, we could start to see some large monthly net outflows, and it shouldn’t come as a surprise if large outflows increase the perception of risk and so encourage further large outflows. Remember that outflows mean dollars sold by the PBoC in exchange for RMB, which represents a contraction in the base money supply. If China is forced to experience a sharp monetary contraction on top of its economic adjustment, things could easily get out of hand.

A sharp monetary contraction, as I see it, basically means a sharp contraction in credit. Could we see this, and can the PBoC take steps to counteract it? Here is what the South China Morning Post had to say in an article two days ago

Yuan-denominated loans granted by mainland banks grew a robust 19 per cent last month from a year earlier, suggesting lenders are heeding Beijing’s calls to stimulate the economy. Mainland banks extended 740 billion yuan (HK$839.31 billion) in loans in December, the biggest monthly rise since January last year, the Shanghai Securities News reported yesterday.

The new loans started to rise from about 300 billion yuan monthly in most of last year to 476.9 billion yuan in November when the central government unveiled a 4 trillion yuan fiscal stimulus package and encouraged banks to help funding the toll road, railway, port and other projects under the scheme. “Bank lending has been a key indicator. It’s crucial to China’s economy-boosting efforts. The December figure shows the needed credit expansion is on the way,” said Peng Wensheng, an economist with Barclays Capital Research.

I am not sure I agree with Peng Wensheng. We are not seeing credit expansion so much as a growth in RMB-denominated loans in the formal banking system. Perhaps this is a good proxy for credit in China, but I suspect it isn’t. First, much of the growth has come in the form of a sharp increase in bill discounting, and I am not sure whether this might not include a lot of double counting. I have also heard whispers that companies are turning to short-term credit not for investment purposes but rather because of serious cashflow problems. If so, this might be the worst sort of credit expansion.

And second, it is not clear what is happening to off-balance sheet transactions – which may be in the process of being shifted back on balance sheets to meet credit targets with no real expansion in credit – or, more importantly, to the informal banking sector. The anecdotal evidence is that the latter is contracting sharply, which is consistent with the idea of hot money outflows.

Whether credit is indeed expanding or in fact contracting is, to me, still an open question, and I would argue that circumstantial evidence – the collapse in inflation, the open disgruntlement among banks about pressure to meet credit expansion targets, hot money outflows – suggest that it is contracting.

Frankly I am not sure where all of these musings lead, and I need to do a lot more thinking about the subject, but I worry that for reasons beyond the PBoC’s control we may see a much sharper monetary contraction in China than expected, especially if hot money outflows increase, and this could seriously exacerbate the downturn just as it did in the US in the 1930s. Can the PBoC accommodate this by relaxing? I don’t think so. Remember that I have argued for years that the PBoC has little to no real control over domestic monetary conditions as long as it retains the straitjacket of the currency regime. It should have gotten out years ago, or at least reduced the strength of its pro-cyclical impact by revaluing sharply before hot money flooded into the economy, but I am not sure it can easily adjust in the midst of a crisis. Perhaps they should anyway consider what the impact would be of either loosening the band considerably, or even floating.

3 Responses to "Monetary conditions might exacerbate the Chinese adjustment"

  1. Guest   January 17, 2009 at 1:42 pm

    China Central Bank Attacks Paulson’s ‘Gangster Logic’By Li Yanpinghttp://www.bloomberg.com/apps/news?pid=20601087&sid=an1lSsWKeDs0&refer=homeJan. 16 (Bloomberg) — A Chinese central bank official attacked reported comments by U.S. Treasury Secretary Henry Paulson that China’s high savings rate helped trigger the global credit crisis.“This view is extremely ridiculous and irresponsible and it’s ‘gangster logic,’” Zhang Jianhua, the bank’s research head, said. His comments were in an interview with the state-run Xinhua News Agency, posted on a government Web site today.Commentaries by China’s state media this month had already accused Paulson and Federal Reserve Chairman Ben S. Bernanke of playing a “blame game” over the cause of the crisis.Friction between the two nations includes a U.S. complaint to the World Trade Organization last month that China uses prohibited subsidies to boost exports. The U.S. also regards China’s currency, the yuan, as undervalued and a factor in global trade imbalances.Massive savings accumulations in countries such as China helped to trigger the crisis by squeezing interest rates and pushing investors toward riskier assets, the Financial Times reported Jan. 2, quoting Paulson.Zhang countered that U.S. policies that aggravated imbalances in that nation’s economy, which was excessively dependent on consumer spending, were a key cause. He also cited failures in corporate governance and risk management at investment banks.‘Finding an Excuse’“The ‘China-responsible theory’ is an attempt by major western economies to find an excuse for their own policy and regulatory failures,” Zhang said in the transcript. “I’m afraid these countries are also finding an excuse to issue trade protection measures or impose pressure on China in the future.”Zhang also criticized the International Monetary Fund for paying too much attention to financial risks in emerging and developing economies and not enough to those of developed countries, “which have a larger impact, especially economies issuing major reserve currencies.”The organization also didn’t respond quickly enough to the crisis, he said.China’s trade surplus is partly caused by developed nations’ restrictions on technology exports, Zhang said.

  2. Victor   January 17, 2009 at 3:37 pm

    Michael, you are famous. The Chinese version of the above story also blames “certain Western academics!” Watch out, the MSS is good with bugging devices!Anyway, that is precisely China’s strategy: it’s clear that they don’t care about NPLs any more. In a recent set of decrees issued by the CBRC, it urges banks to provide loans to firms hit financially by the global slow-down–AKA firms in dire need of short term working capital. The government is willing to take a big hit in the banking sector to maintain employment.But then you ask, “wait, these banks are now listed–they can’t do that!” Well, they can, since CIC is stepping in to support bank shares at a minimal level in the A share for sure and probably in the H share. Before investors get too giddy, however, they should note that the CIC will only intervene to prevent the bottom from falling out. NPLs will continue to weigh on the heads of banks for years to come with CIC only buying back higher and higher share of listed bank shares. Also, this gamble only pays off if China’s growth climbs back to the 9% range.

  3. George HArter   January 18, 2009 at 5:17 am

    Very glad I am now able to read sound solid economic analyses of the Chinese economy. Thank You Mr. Pettis.One thing I think is being left out here, however. A considerable portion of China’s historical customer base, is gone. Probably permanently. Indonesia is only the first country headed for confrontation with China.As we have sen in Japan, regardless of the political flack, exports WAS their economy. China will also be getting hammered by the real downturns in both the US and Japanese economies.With the closing of many export oriented factories, a trend which WILL continue due to lack of markets, resulting unemployment rates in China are a literal threat to the security of that state. More, we should not forget that this industrial throw away (the Chinese Labor Pool) will lose acquired work experience and training as they are scattered to the winds.They are only rumors, but Chinese friends have told me that many shuttered factories (especially Taiwanese) have been looted and trashed in Shen Zhen and other Canton exurbs.This is a round about rant on my part which concludes that Monetary policies may be important to dveloped peaceful economies, but I don’t think they really matter in an imploding economy (polity, society) which is on the verge of possible social calamity, maybe insurrection.In a way this near disaster is as inevitable as our own economic blowout. (Will the global economy want to absorb $1-2 trillion per annum of shaky US debt? Will China be there as a buyer of last resort for 50% of Federal Notes sold at auction?) My answers are of course NO and HELL NO!Monetary tinkering will not change the fact that the economies of the US and China and Japan are now wedded, for better or for worse, in a gigantic economic mess. They will not do much to ameliorate or prevent the coming catastrophes in China. Japan and the US will be suffering too and I believe the economic damage is has dimensions that monetary policy was never intended to address.