August 19,2008

China's Excess Liquidity Trap

By Pieter Bottelier
In spite of the fact that average per capita income is still very low (about $2,500 in 2007), China has become a super well-funded country.  Household deposits in the banking system are very high and increasingly liquid; large enterprises are on average very profitable and cash-rich; the government ran a budget surplus in 2007; the country is a net exporter of capital and has more foreign exchange reserves than it knows what do with.
While this situation may sound positive, the associated imbalances in China’s economy are large and increasingly worrisome for China’s leaders. The way China deals with these challenges will have significant national and international implications.
Japan’s inability to stimulate growth through a reduction in the central bank’s discount rate during the1990s (because the rate had already been reduced to zero or close to zero), was described by economists as a "liquidity trap". There was no easy way out for Japan. China’s problem today is in some ways the opposite. One might refer to it an excess liquidity trap. It has 3 dimensions, all of which present serious policy dilemmas:
China has to be concerned that excess domestic liquidity will cause economic overheating, but is afraid to raise interest rates and tighten monetary policy more aggressively for fear that it would slow employment growth, generate additional non-performing loans in the banking system and attract additional liquidity from abroad.
China cannot continue to sterilize large amounts of excess liquidity in the banking system indefinitely without risking a qualitative deterioration of PBoC’s balance sheet, a decline in the profitability of banks (if reserve requirements are raised too high) or other monetary problems.
It is difficult to protect the value of China’s huge foreign exchange reserves against dollar decline precisely because the reserves are so huge and because the dollar’s share in those reserves is so large.
The Inflation Challenge
The increase in China’s consumer price index (CPI) for the first 5 months of 2008 reached a worrying 8 percent (yoy), the highest level in more than a decade. This is the first serious CPI inflation in China since the inflation cycle of 1992-1995, but the factors underlying it are very different.
For most of the period between 1998 and early 2007, China’s CPI was very low or negative. Unlike China’s inflation of the early 1990s, which was driven by an overheated economy (rapid domestic demand growth fueled by excessive credit expansion), the current inflation cycle was ignited by incidental domestic supply-side factors in the food sector (mainly pigs and poultry), reinforced by sharp global price increases for imported oil, coal, soybeans, other grains and metals. The combined effect was to drive up the price of many food items (especially pork, poultry, eggs, vegetable oil and dairy products). CPI inflation received an extra jolt in the early months of 2008 as a result of unusually severe winter storms which disrupted transportation and power supply in Southern China. The non-food CPI has remained surprisingly modest and stable , but the producer price index (PPI) ?a contributor to CPI inflation in the longer term -  has risen sharply in recent months, to 8.2 percent in May.
The increase in GDP growth from 10.1 percent in 2004 to 11.9 percent in 2007  was almost entirely due to increases in net external demand (trade surplus), not domestic demand. Monetary expansion in 2007 was moderate; it was not a primary cause of either CPI or PPI inflation. 
Although China’s rising import demand for soybeans, oil, coal, metals and other commodities has undoubtedly contributed to the global commodity price increases of recent years, from a policy perspective such price increases have to be seen as exogenous. Because of the size of its economy and high growth, China’s rapidly growing imports of many commodities has a major impact on international prices. However, China cannot be expected to slow domestic demand growth to reduce international commodity prices, unless such action is indicated by domestic policy requirements.
Aggregate bank deposits in China ?constituting the bulk of broad money supply (M2) ?have become very large and are still growing. The total reached almost RMB40 trillion ($5.6 trillion, over 160 percent of GDP) at the end of 2007. The total was composed of about RMB26 trillion ($3.6 trillion) in household deposits and about RMB14 trillion ($1.9 trillion) in enterprise deposits. In view of the large absolute size of bank deposits, the implications for international capital markets of a relaxation of controls on private capital outflows from China are potentially significant. However, it is unlikely that there will be sudden large outflow of bank deposits from China soon, as will be explained later. 
Since 1999 the composition of household deposits has been slowly shifting from saving (term) deposits to demand deposits. This shift probably reflects a growing need of households for liquid assets to finance the purchase of consumer durables (e.g. cars), shares and down payments for real estate. It is not clear why this shift accelerated in 2004, but a plausible explanation lies in the fact that CPI inflation began to exceed the one-year deposit rate that year.It is not clear either why the share of saving deposits slightly increased in the first quarter of 2008.Enhanced liquidity of M2 does not automatically contribute to inflation, but it increases the risk that inflation will become more serious and endemic should inflation expectations become part of market psychology.
When inflation is driven by exogenous factors beyond the government’s control, as has been the case since early 2007, a further tightening of monetary policy may have perverse effects, as it would slow growth without necessarily reducing inflation. Yet, as the government knows from past experience, social tolerance for inflation in China is low, regardless of its source. The government is obviously concerned that a prolonged period of relatively high CPI inflation may generate inflation expectations which could trigger new inflation dynamics that are even harder to control. In this context the increasing liquidity of China’s broad money supply (M2), as already noted, is worrisome. It does not necessarily trigger inflation, but it facilitates inflation should expectations and systemic cost-push factors take over as a driving factor. To control M2 liquidity ?as a general rule - China should ensure that deposits rates are positive in real terms (with respect to CPI inflation). In the longer term it should also try to reduce the M2/GDP ratio through domestic capital market development and a gradual liberalization of capital controls.
The Sterilization Challenge
The central bank’s main target for monetary policy is the margin of loanable funds in the banking system. This margin may become larger than desired for various reasons, but the most important factor in China in recent years has been the large net capital inflow from abroad as is reflected in the steep increase in foreign exchange (from $291 billion at the end of 2002 to $1.76 trillion at the end of April 2008). During the first 4 months of 2008 China’s reserves increased by an average of $80 billion per month which would add about $1 trillion to China’s reserves this year if the trend continues! The accumulation of foreign exchange reserves is in large measure due to China’s intervention in foreign exchange markets to keep the RMB/USD exchange rate fixed (until the RMB was de-linked from the US dollar on 21 July 2005) or to prevent it from appreciating faster than the government feels comfortable with (after 21 July 2005).
Thus far, China’s central bank has been surprisingly successful in sterilizing excess liquidity in the banking system that resulted from the sharp increases in net foreign exchange inflows since 2002. This virtually eliminated inflationary pressures that would otherwise have resulted from excessive credit expansion and thus prevented the real exchange rate from appreciating. As mentioned, the CPI inflation that started in 2007 was driven by domestic supply-side disruptions in the food sector and international price increases for certain key commodities, not by excessive domestic credit expansion. From the end of 2006 PBoC tightened monetary policy to the point that the amount of loanable funds in commercial banks actually contracted, creating higher and considerably more volatile short-term interest rates in the domestic money market.
On average the central bank has sterilized a little over 70 percent of the additional domestic money supply that resulted from net foreign exchange reserve increases since 2002. This was accomplished through a combination of open market operations (sale of central bank bills) and increases in bank reserve requirements. 
From the fourth quarter of 2007 domestic short-term interest rates in China began to exceed short-term interest rates in the US for the first time since late 2005 . Since then, PBoC has incurred losses on sterilization through open market operations, whereas it generally made a profit on such operations earlier. This may explain why PBoC began to rely more heavily on upward adjustment of bank reserve requirements instead of the sale of central bank bills. Such adjustments shift part of the cost of sterilization from the central bank to commercial banks. If an upward adjustment of the reserve requirement ratio merely skims off the extra liquidity resulting form an increase in foreign exchange reserves ?as is usually the case - the measure should not be characterized as "monetary tightening", as the financial press often erroneously does.
Although sterilization has become more problematic since domestic short-term interest rates began to exceed US rates, China can continue its policy of suppressing nominal RMB appreciation and sterilize resulting excess liquidity in the banking system for some time. It does have to be concerned, however, about PBoC’s capital base and the soundness of its balance sheet (which can be negatively affected by open market operations) while the profit margin of commercial banks is negatively affected by increases in the reserve requirement ratio. Therefore, there is a limit to sterilization; the policy cannot be continued indefinitely without generating increasingly serious alternative problems.
China’s decision to accelerate RMB appreciation may have been inspired, in part, by the increasing costs of sterilization. Since December 2007, nominal appreciation of the RMB against the dollar increased from about 5 percent p.a. since China’s currency was officially de-linked from the dollar on 21 July 2005 to about 20 percent (annualized) though mid-April. The policy appears to have changed again thereafter. Nominal appreciation against the dollar slowed (perhaps because the decline of the dollar itself seems to have bottomed out), but appreciation against a representative basket of currencies continued, albeit at a very slow pace. 
The Challenge to the Value of China’s Foreign Exchange Reserves
Since 2002 the value of the dollar has declined by about 30 percent against a basket of important convertible currencies. Since China is believed to hold the bulk of its huge foreign exchange reserves in dollar-denominated financial instruments, this is obviously a matter of grave concern to the government. But it is not easy to protect the international value of China’s reserves precisely because they are so huge and because the dollar share of those reserves is so large. Since the international value of the dollar has become so unstable, China is faced with the question what the denominator to monitor changes in its reserves and guide policies to protect their value should be. Alternatives to the US dollar include the Euro, various baskets of currencies, gold, or even baskets of commodities. It is not known if China uses any of these alternative denominators. What is clear, however, is that China cannot diversify its reserves out of dollars quickly without putting downward pressure on the international value of its main reserve asset and putting upward pressure on interest rates in the US which could slow US growth and hence US demand for Chinese exports.
So what can China do to protect the value of it reserves? One option is to diversify the currency composition of reserves slowly by reducing the dollar’s share in incremental reserve assets while increasing the share of currencies that are expected to appreciate. Another option is to try and increase the return on dollar reserves by substituting higher yielding non-US government securities for low-yielding Treasuries. Both options entail risks. According to a recent report by the US Congressional Research Service, China reduced its holdings of Treasuries during 2007, but there is no indication that is also reduced its holding of total dollar securities.
Additional strategies which are actually being pursued include the promotion direct investments abroad by Chinese corporations and the relaxation of restrictions on private capital outflows for portfolio investment, travel and tourism. China is not only the number one destination of FDI in the world, but among emerging economies it has also become the largest source of outward FDI. The recent creation of China Investment Corporation, a $200 billion sovereign wealth fund capitalized from foreign exchange reserves, is another illustration of China’s policy to promote outward investment. Through these policies China is also trying to secure the supply of critical raw materials from abroad, improve market access for its exports, diversify trade - both geographically and in terms of commodity composition, and increase the scale of production and the profitability of its corporations. In other words, China has begun to employ its huge foreign exchange reserves for broad-based long-term development, not just as hedge against possible future balance of payments problems.
Ultimately, the best policy for dealing with excess foreign exchange reserves is to avoid large balance of payments surpluses. Ways to achieve this objective include allowing the real exchange rate to appreciate faster, making the nominal rate more flexible, opening the capital account and liberalizing domestic interest rates.            
 (The author is a senior adjunct professor of economics at Johns Hopkins University.) 



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