Consider this: despite China’s swelling foreign-exchange reserves — the result of persistent current-account surpluses — market and interbank short-term interest rates are soaring. How did this happen, and what should policymakers do about it?
The problem is structural. China’s monetary stock is relatively abundant. As the world’s largest currency issuer, China’s broad money supply (M2) is 1.5 times larger than that of the US, with an M2/GDP ratio of about 200 percent, compared with about 80 percent in the US.
China’s economy is also highly leveraged. In the years prior to the global financial crisis, China’s total debt hovered around about 15 percent of GDP.
However, since 2008, credit expansion has proceeded at a staggering pace, driving the debt/GDP ratio above 200 percent, with private credit alone (including to state-owned enterprises) amounting to 130 percent of GDP.
Moreover, China continues to attract huge amounts of cross-border capital, as advanced countries like the US pursue expansionary monetary policies. According to a recent yuan credit report, the central bank’s — the People’s Bank of China (PBOC) — foreign-exchange reserves climbed to 27.5 trillion yuan (US$4.5 trillion) in September last year, up 126.3 billion yuan from August — the largest monthly gain since April. At the same time, the PBOC’s new renminbi funds outstanding for foreign exchange — the amount of renminbi the central bank spends to purchase foreign-currency assets — totaled 268.2 billion yuan, reflecting a monthly increase of almost 170 billion yuan.
Instead of easing liquidity constraints as expected, these gains have exacerbated them. This was reflected in a spike in the interbank interest rates in October last year, when the seven-day rate soared to 5 percent and the yield on 10-year government bonds reached a five-year high. This is where the paradox plaguing Chinese economic policy lies.
Increasingly strained liquidity seems to be the consequence of all of the government’s recent actions. Earlier this year, the central bank attempted to clean up its toxic assets and promote bank deleveraging. While these efforts contributed to a contraction in asset and debt growth, they also led to a severe liquidity squeeze that rocked financial markets and sent money-market rates soaring in June.
The central bank has since resumed its reverse repo operations — purchasing securities from commercial banks with an agreement to resell them in the future — thereby injecting liquidity into the banking system. However, given a rising bidding rate, peaking capital costs and restrictions on the downstream transfer of assets, these efforts seem unlikely to ease the strain.
Clearly, China’s problem is not insufficient assets or liquidity. Rather, capital-structure and maturity mismatches — a result of the rapid and uneven buildup of debt in the past five years — have distorted the allocation of resources, leading to non-performing, idle and inefficient assets, thereby amplifying the financial system’s hidden flaws and increasing risk.
Furthermore, the financial system has become excessively dependent on credit, especially when it comes to risk assets.
With financing channels extremely limited, banks have been forced to participate heavily, assuming substantial risk, which is aggravated by underdeveloped bond and stock markets.