How do you turn this thing off?”
That question, posed by Beijing-based blogger Michael Pettis on 21 March, pertains to China’s record-breaking build-up of currency reserves. It’s an excellent one that connects events in Beijing and Washington like few others.
Press reports and analysts’ estimates that China’s reserves approached $1.7 trillion (Rs68.17 trillion) in February raise more questions than answers, according to Pettis, a Peking University finance professor. It’s unclear where as much as $30 billion of the estimated $57 billion increase came from.
“It can’t all be hot money, of course, but all the circumstantial evidence seems to suggest that hot money is accelerating,” Pettis says.
Few phenomena worry Asian policymakers more than “hot money.” Speculative capital flows wreaked havoc in the region a decade ago as investors who had poured in amid rapid growth fled even faster at the first sign of trouble. More and more of the liquidity created by the Federal Reserve’s interest-rate cuts is heading China’s way.
The meltdown at Bear Stearns Companies Inc Inc is raising the stakes for Asia.
Even before the fifth largest US securities firm was saved by the Fed, the central bank had been aggressively cutting its benchmark lending rate. Following Bear Stearns’s collapse, the Fed reduced rates by 0.75 percentage point and pumped out billions of dollars in cash on top of that.
As much of that money searches for higher-yielding assets than the US offers, Asia is an obvious destination. China is often the biggest beneficiary of excess dollars zooming around the globe. These days, of course, Chinese officials don’t see the dynamic as a benefit.
People’s Bank of China Governor Zhou Xiaochuan is grappling with inflation that surged to 8.7% in February. Increasingly, the evidence points to more being at play than rising commodity prices. Rapid money-supply growth is working the way economist Milton Friedman always said it would. Too much money eventually equals too much inflation.
“It seems that with reserve growth accelerating and, with it, monetary expansion that occurs as the PBOC is forced to buy reserves, it’s going to be almost impossible to rein in the overheating and inflation that plague the economy,” Pettis says. “I am afraid that for all the talk and action, things are getting worse, not better.”
Not everyone agrees China has a sudden hot-money quandary on its hands. Stephen Green, senior economist at Standard Chartered Bank Plc. in Shanghai, says foreign exchange lending by Chinese banks was “huge” in February. He suspects most of it got converted and ended up on the central bank’s books as currency reserves.
Even so, China’s estimated reserve growth in January and February probably far outpaced growth in the same period in 2007. Brad Setser, a fellow at the Council on Foreign Relations and a blogger, says the race to amass reserves highlights an unsustainable global monetary system. He reckons reserve growth in China and Saudi Arabia in January alone equalled the monthly US current-account deficit.
Perhaps what’s most surprising about recent increases in China’s reserves is how unsurprised economists are. They have almost become desensitized to the sheer magnitude of liquidity increases in Asia’s second biggest economy.
Yet, few trends say more about the unique and growing relationship between the US and China. It’s not only that they are arguably the two most-watched economies. It’s that China needs US demand for its goods to thrive and the US needs China’s money to finance its demand.
The way Fed Chairman Ben Bernanke stepped in to keep Bear Stearns afloat before JPMorgan Chase & Co. did, turned heads around the globe. The economy with the most at stake from the action—after the US—is China.
Bear Stearns’s troubles were endemic of a financial system in chaos. Fearing panic on Wall Street and elsewhere, the Fed made it clear it’s willing to take unconventional steps to restore calm. That’s creating expectations that the US will keep pumping liquidity into markets, and much of it may head China’s way.
All this poses quite a central-banking dilemma for China. On 18 March, Premier Wen Jiabao pledged to take “forceful” steps to cool inflation at an 11-year high, a sign that overheating remains China’s main concern even as market turmoil threatens global growth.
The Fed’s actions raise questions about how China can do that. China isn’t ready to let the yuan trade freely or rise drastically, which is why it accumulates so many reserves to begin with. Without developed bond markets, Zhou’s rate increases won’t tame the economy. Besides, higher rates only boost the attractiveness of Chinese assets. Such moves may just attract more hot money to China.
Officials in Beijing are determined to maintain stability before the August Olympics. That’s becoming harder as the Fed keeps the monetary floodgates open.
So, the answer to Pettis’s how-can-China-turn-this-thing-off question may be that it can’t. China hasn’t lost control of its economy, though the Fed’s post-Bear Stearns policies complicate the country’s ability to stay on course.