Friday, April 18, 2014
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Quitting the Quota

HONG KONG – On March 1, China’s State Council announced a new batch of restrictions aimed at reining in property prices by curbing speculative demand. The measures include tighter limits on home purchases by non-locals in cities with excessive price gains, a reinforced 20% capital-gains tax, mandatory 70% down payments, and a 30% benchmark interest-rate premium for second mortgages.

While the previous round of housing-sector restrictions, implemented less than two years ago, dampened market sentiment temporarily, it failed to curb rising property prices. Likewise, although the latest measures might have some impact, cooling China’s turbulent property market – which relies on cheap credit – in the long term will require addressing underlying monetary-policy weaknesses.

In order to control the money supply, the People’s Bank of China (PBOC) has long used credit quotas as “window guidance” to banks. The policy is rooted in central planning, which, three decades ago, led to artificially low prices and, in turn, to shortages of basic necessities and key production inputs, such as grain and steel. As the free market developed, a dual-price system emerged, in which those with access to quota-allocated goods paid less. As a result, the government was compelled to grant subsidies to the system’s “losers” – such as urban residents and state-owned enterprises (SOEs) – until strong supply responses to rising market prices eliminated the need for quotas on manufactured products.

A decade later, in response to the global financial crisis, China loosened credit quotas and planning controls on SOE-run local-government infrastructure projects. Between November 2008 and June 2009, China’s banks issued more than ¥8.6 trillion ($1.3 trillion) in new loans. As a result, the rate of credit growth increased from 14% in September 2008 to 35% a year later, and property prices more than doubled in many cities.

Excessively low interest rates have generated a mismatch between housing prices and the available supply, because they serve as hidden subsidies for those who can borrow – for example, the rich and SOEs – and thus stimulate demand for luxury property. In order to curb this trend, policymakers have reverted to the quota as a macroeconomic tool, but this time for housing credit.

Like quotas on manufactured products, these new quotas are generating a dual-price allocation system, in which SOEs can borrow at significantly lower interest rates than small and medium-size enterprises (SMEs), which must rely on the informal market at interest rates as high as 2% monthly. But eliminating quotas in order to allow prices to reach market-clearing levels is not an option this time, owing to the complexity and competitiveness of the real-estate and bank-credit markets.

Three major factors are impeding policymakers from raising interest rates to market-clearing levels. First, the domestic interest groups that benefit from low borrowing costs have become a barrier to their liberalization. There is a “common-sense consensus” among borrowers – in China, as well as in highly indebted advanced economies – that raising interest rates would undermine GDP growth, employment, and asset prices.

Second, many argue that raising interest rates would trigger a flood of speculative capital from low-yielding advanced economies. With the PBOC unable to sterilize the inflows, upward pressure on the renminbi’s exchange rate would threaten competitiveness.

Finally, an inadequate understanding of structural inflation (the growth in prices for non-tradable assets) has generated the false belief that China can maintain similar levels of inflation and exchange-rate stability as the OECD economies. As a result, over the last decade, the Chinese authorities’ implicit target for annual inflation and currency appreciation has been only about 3%.

But China has attained much higher GDP growth than the OECD economies, driven largely by the rapid productivity gains that characterize the initial “catch up” phase of emerging-market development. As China continues to implement market-oriented reforms, the prices of non-tradable assets – such as property, natural resources, utilities, services, and wages – will continue to rise much faster than in the OECD countries, until they eventually converge. This process will inevitably lead to higher structural inflation and currency appreciation in China.

If nominal interest rates are lower than the real return on investment – associated with GDP growth – the result is financial repression and increased income and wealth inequality. To avoid this outcome, as long as China’s GDP growth exceeds that of OECD economies, its nominal interest rates must also be higher, its exchange rate must be more flexible, and it must tolerate higher structural inflation.

Indeed, despite domestic resistance, the PBOC must raise nominal interest rates so that they are in line with structural inflation. Such a move would deter excessive investment in productive capacity, and ease the implementation of a more flexible exchange-rate regime. At the same time, one need only recall the damage that unregulated carry trades wrought on Asian economies in the 1990’s to understand why China must erect barriers to protect its domestic markets from inflows of hot money.

The alternative to this price-oriented approach – continued dependence on the quota system – would incur considerable administrative expenses, efficiency losses, and social costs stemming from rent-seeking and corruption. Much like the quota system of 30 years ago, the current reliance on quotas is unsustainable in the long term.

To manage exorbitant demand for financial and physical assets, China’s leaders must address its root cause: the low cost of capital. Doing so will require maintaining some capital-account control, while raising interest rates to market-clearing levels. This, not the unsustainable imposition of quotas, is the real monetary-policy challenge facing China today.

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  1. CommentedJonathan Lam

    Gamesmith94134: Quitting the Quota
    I thought Mr. Sheng was complaining the current of the hot cash was so strong that “quitting the quota” was an alternative to halt inflation and inequality in the micro economic model. Luckily, I appreciate Mr. Alton Cheung gave me the different look on the IV therapy. Did Mr. Sheng confused of the dark matter inside of the horn? If the asset class capital is intruded by the low cost of RMB that he assume China should make it compatible to OCED to survive; then I think the elephant is not piece of rope nor a wall.
    Perhaps, I read on the restrictions and demands on the asset class capital; and the locals are not yielding on profitability. Over the years I returned to China, I saw bicycles disappeared and reappeared in the metros, why should China build more prestige village for the wealthy? If the SOE is competing with the foreigner in occupying the valuable properties; why can’t China subsidize the lesser wealthy one to own one if they are not catching on with its prices? We, American have policy in provision on the elderly to live in the fancy one and we do not fend off building to be prestige and they became cheaper; and I thought China was tough enough to say “NO”. Why should Beijing or Hong Kong fear of the smog?
    If transportation is not a problem for China to implement its policy; it is time for the non-resident workers in the metro to go home where the Politburos can guarantee a livelihood for them. Mr. Sheng, why should you fidget with the interest rate if the others are relatively low? Or compensate those seeking on the profitable if the 2013 is uncertain in term of the currency war?
    I would suggest the case of “Khodorkovsky worked his way up the Communist apparatus during the Soviet years, and began several businesses during the era of glasnost and perestroika. After the dissolution of the Soviet Union, he accumulated wealth through the development of Siberian oil fields as the head of Yukos, one of the largest Russian companies to emerge from the privatization of state assets during the 1990s”in the example on the transformation.
    Quitting the quota does not work; and SOE’s are not benefiting of the lower rate, and SME’s will suffer more. I emphasized my suspicion the BRICS is contaminated with the current and influenced by the global macroeconomic policy; that, oblivion of domestic measures through the micro economic principle are not adequately executed. Eventually, the boom becomes the shift on the politics that inequality turned many economists into drunken sailors after the change of attitudes of their politicians. Take the case of Libor and EU. Then, my statement in the status quo is doomed to a diminishing return and depression is not far away even for China.
    Finally, Currency is the margin of affordability that required its citizens to support and defy; that economists must yield or examine well just before advise on it politicians to pursuit its goal. Harmony is the name of the game; why is BRICS is compatible to OCED? Citizen to the world just make me laugh. Hang on, we do need a global financial reform; don’t bet on the chips till you are at the table.
    May the Buddha bless you?

  2. CommentedAlton Cheung


    I don't see it as a form of "financial repression" either. This article only tells half the story.

    The issue is not so much about low nominal interest rate; rather, it is about China's reaction to the global crisis with its dual-track and state heavy system. Inequality happens because increasing money supply and lowering interest only benefited all the SOEs because private SMEs cannot get credit from state-owned banks.

    Since China is dependent on exports and thus having a low exchange rate and an excessive surplus, inflation is inevitable. If it tries to tighten up money supply and interest rate, its economy will tank immediately as we have seen during 2011-2012. One of the many problem with this policy is that most Chinese producers are already having excessive capacities, and Chinese still do not have enough purchasing power, so the best way to use the cheap loans is to invest in real estate. Then this would mean only the people who are able to receive the cheap loans, i.e. rich people, will be able to own real property. The article is kind of right on this.

    Then it went off track for its conclusion. The problem is not low borrowing cost. Rather, it is the dependence on export and its its inability to raise purchasing power: the low borrowing cost is merely the IV therapy for its export sector.

  3. CommentedProcyon Mukherjee

    The last quarter has shown PPI at 2.2% and CPI at 2%, which makes interest rates balance the inflation; do not see how one can surmise that cost of capital is out of sync with inflation.

    What China has shown is that central planning even in a capitalist economy can deliver results what 'the market clearing mechanism' is supposed to do, although it would be naive to imagine that the latter is completely absent in China.

  4. CommentedKen Presting

    I'm surprised by the usage of "financial repression" in this article. The term is familiar from Keynesian literature, but it usually refers to interest rates which are lower than inflation. And it doesn't promote inequality, but rather is part of "euthanasia of the rentiers."

    If any other readers can clue me in I'd appreciate it.

    Otherwise, this article is outstanding in technical depth.

  5. CommentedFrank O'Callaghan

    Can China distribute the wealth, work, power and leisure among it's people without the gross inequalities that capitalism brings? Does it want to? What happens if it fails?

    Inequality is the core issue.