After all the traders had hit the pubs in Singapore on Friday evening, China announced an increase in the reserve requirement for banks taking it to 19%. Further, it brought forward the release of the Consumer Price Index data to Saturday from Monday. The data revealed that the Consumer Price Index inflation in November was 5.1%. The official inflation target is 3%. This explains the reserve requirement decision on Friday. A higher reserve requirement chips away at banks’ ability to lend by forcing them to hold more cash against their deposits.
Also Read V. Anantha Nageswaran’s previous columns
Last week, Paul Cavey, the China economist at Macquarie Securities, brought out a very detailed piece on the challenges of policymaking in China. It is well worth a read. Unsurprisingly, its policymaking challenge has become that much more complex in recent times. What follows is based on Paul Cavey’s note.
In China, monetary policy is still not conducted using interest rates. It is conducted using bank lending quotas and reserve requirements. Interest rates are useful to encourage the flow of deposits into banks and to prevent their diversion to more speculative investments such as stocks and property.
Then, there is the export growth objective, which is pursued with an undervalued exchange rate. This worked reasonably well in the past. Interventions in the foreign exchange market to keep the value of the Chinese currency from rising against other currencies would normally boost domestic money supply, hold down interest rates and thus boost credit demand. But China was able to handle the fallout in the past.
First, intervention was profitable, as China could invest the accumulated foreign currency reserves in higher yielding investments. Thus, returns earned on the foreign exchange reserves exceeded the cost of issuing sterilization bills. The globalization of zero interest rate policy has made that impossible now. Accumulating foreign exchange reserves to hold the renminbi down is loss-making now.
Second, China could use its executive authority with effectiveness to regulate the flow of credit to the economy. That is why in the boom years of 2002-07, China’s credit growth did not exceed its nominal gross domestic product growth rate. The command economy model worked well. It is not working as well now, for two reasons.
One is that there is a fairly large shadow banking system, which dilutes government directives on credit disbursement. Second, there has been a certain loss of policy credibility earned in the Zhou Rongji years. Then, China implemented a draconian tightening of monetary policy to kill inflation. That included drastic curbs on credit growth too. If the government talked tough, the public believed that it would follow through on it. It is still largely the case, but the fear has frayed at the margin because the government made an abrupt U-turn in its policies after the Olympics in 2008.
China was actively tightening monetary policy in 2007-08. Post-Olympics, Lehman Brothers collapsed as did trade finance and the world economy suffered a sharp contraction. China announced a massive fiscal stimulus and loosened its monetary policy stance. It persisted with these policies well into 2009. In 2010, even as it announced various administrative measures to cool the property market, monetary policy remained “moderately loose”. Only recently was it relabelled as “appropriately prudent”.
Now China is back to hiking reserve requirements and is set to push up interest rates a lot more, similar to what it did in 2007-08. At the same time, it is trying to hold back too rapid an appreciation of its currency. The crucial difference now from 2007-08 is that the developed world policies are not supportive. If anything, their stance is denying China the luxury of time to bring about a gradual rebalancing of its economy.
Therefore, this double-barrelled attack on aggregate demand, on inflation expectations and on redirection of capital to speculative investments risks two things: one, economic growth could slump much more than expected; second, reduction in aggregate demand in the economy would lower import growth and boost trade surplus, delaying the rebalancing that the US seeks (not that the US is doing much, if at all, to keep up its end of the bargain). Thus, it raises risks of a trade war between the two.
China’s policy conundrum might appear intractable, but there are mitigating factors. Rural spending is boosted by growth in rural incomes. Infrastructure spending is doing its bit, too, to boost growth rates. Further, China can still rely on growth in the labour force (until 2014) and productivity help to sustain economic growth around 8%.
Nonetheless, China’s tightrope policy act will cause more volatility in regional financial markets. In fact, in the next few months, emerging market stocks would perform less well compared with their developed country peers, principally due to the China effect. Beyond that, China’s administrative micro management of its large economy is not just a technocratic challenge. It is an existential one for the Communist Party. How it resolves that question would determine peace, stability and growth prospects in the region in the coming decade.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org