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.
In such a concentrated risk environment, any shock could amount to a systemic blow to the financial sector.
Making matters worse, the financial sector is increasingly diverging from the real economy. As the money supply grows, capital efficiency declines.
With a substantial share of financial resources being allocated to infrastructure and real-estate development, which have lower output efficiency, capital has tended to circle back into the financial system instead of flowing toward activities in the real economy. Finally, China’s balance-sheet recession has barely begun.
Since 2008, liquidity-thirsty local governments have used a variety of measures, including off-balance-sheet loans and interbank debt financing, to channel capital into local-government financing vehicles and state-owned companies. This has driven up the debt ratios of governments, businesses and banks, causing their balance sheets to deteriorate rapidly. Now, the pressure to deleverage is on — a process that will inevitably lead to liquidity tightening.
Debt repayment is critical to a functioning financial system. According to US economist Irving Fisher’s long established “debt-deflation” theory, when an over-indebted economy suffers a shock, the joint effects of debt and deflation can trigger a downturn. Such an outcome would cause public and private-sector balance sheets to deteriorate further, raising fears of default and increasing the cost of financing. Subsequent efforts to deleverage would cause balance sheets to contract and reduce the money multiplier, thereby diminishing confidence and hurting borrowing.
These changes in risk appetite are already contributing to a rising preference for cash. While cash hoarding pushes down nominal interest rates by reducing currency in circulation, the rapid decline in inflation will drive up the actual interest rate, thereby aggravating the debt burden.
In short, China’s liquidity troubles are rooted in the recent buildup of leverage, which has triggered debt deflation. Macroeconomic policy should not only reduce borrowing and financing costs through cuts in interest rates and reserve requirements, but also work to strengthen balance sheets.
That means abandoning the investment-driven growth model, promoting deep monetary and financial reform, boosting investment efficiency and resource allocation and improving the government’s functioning.
This is a tall order — one that can be met only by a long-term commitment from policymakers.
Zhang Monan is a fellow of the China Information Center, a fellow of the China Foundation for International Studies and a researcher at the China Macroeconomic Research Platform.
Copyright: Project Syndicate
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