Friday, November 28, 2014

Controlling China’s Currency

BEIJING – It is indisputable that China is over-issuing currency. But the reasons behind China’s massive liquidity growth – and the most effective strategy for controlling it – are less obvious.

The last decade has been a “golden age” of high growth and low inflation in China. From 2003 to 2012, China’s annual GDP growth averaged 10.5%, while prices rose by only 3% annually. But the unprecedented speed and scale of China’s monetary expansion remain a concern, given that it could still trigger high inflation and lead to asset-price bubbles, debt growth, and capital outflows.

Data from the People’s Bank of China (PBOC) show that, as of the end of last year, China’s M2 (broad money supply) stood at ¥97.4 trillion ($15.6 trillion), or 188% of GDP. To compare, M2 in the United States amounts to only roughly 63% of GDP. In fact, according to Standard Chartered Bank, China ranks first worldwide in terms of both overall M2 and newly issued currency. In 2011, China accounted for an estimated 52% of the world’s added liquidity.

But a horizontal comparison of absolute values is inadequate to assess the true scale of China’s monetary emissions. Several other factors must be considered, including China’s financial structure, financing model, savings rate, and stage of economic development, as well as the relationship between currency and finance in China.

China’s intensive economic monetization is a key factor driving its money-supply growth. But China’s sharply rising monetization rate cannot be judged against the high, steady rates of developed countries without bearing in mind that China’s monetization process began much later, and has distinct structural and institutional foundations.

As China has opened up its economy, deepened reforms, and become increasingly market-oriented, the government has facilitated the continuous monetization of resources – including natural resources, labor, capital, and technology – by ensuring their constant delivery to the market. This has fueled rising demand for currency, leading to the expansion of the monetary base, with the money multiplier – that is, the effect on lending by commercial banks – boosting the money supply further.

And, as GDP growth has become increasingly dependent on government-led investment, currency demand has continued to rise. Indeed, the rapid expansion of bank credit needed to finance skyrocketing government-led investment is increasing the amount of liquidity in China’s financial system. As a result, in the last four years, China’s M2, spurred by a stimulus package totaling ¥4 trillion in 2008 and 2009, has more than doubled.

This trend is exacerbated by the declining efficiency of financial resources in the state sector, a product of the soft budget constraint implied by easily accessible, cheap capital. Consequently, maintaining high GDP growth rates requires an ever-increasing volume of credit and a continuously growing money supply. So China is stuck in a currency-creating cycle: GDP growth encourages investment, which boosts demand for capital. This generates liquidity, which then stimulates GDP growth.

The key to controlling China’s monetary expansion is to clarify the relationship between currency (the central bank) and finance (the financial sector), thereby preventing the government from assuming the role of a second currency-creating body. According to Pan Gongsheng, a deputy governor of the PBOC, the relationship between the central bank and the financial sector entails both a division of labor and a system of checks and balances. In theory, the financial sector serves as a kind of accountant for the treasury and the government, while the PBOC acts as the government’s cashier.

In practice, however, the relationship between currency and finance is vague, with both assuming quasi-fiscal functions. China’s low official government debt largely reflects the role of currency in assuming quasi-fiscal liabilities – not only the write-off costs incurred from reforming state-owned banks, but also the takeover of banks’ bad debts via note financing and the purchase of asset-management companies’ bonds. These activities both damage the PBOC’s balance sheet and constrain monetary policy.

At the same time, finance takes on quasi-fiscal functions by excluding government fiscal deposits – government deposits in the national treasury, commercial banks’ fiscal savings, and central treasury cash managed through commercial-bank deposits – from the money supply. Given the large volume of fiscal deposits – which totaled ¥2.4 trillion (3.3% of M2) at the end of 2010 – their impact on the money supply cannot be ignored.

Clarifying the relationship between currency and finance is essential to ensuring that all newly issued currency is backed by assets. Only by exerting a harder budget constraint on the state sector, limiting fiscal expansion, and reducing dependence on government-led investment can China’s excessive currency issuance be addressed in the long term.

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    1. CommentedJonathan Lam

      Gamesmith94134: Controlling China’s Currency
      During the last week visit in Guangzhou, high rises are building in every block; at least, I saw cranes are over my head. It was fabulous to see a new China and even my mother in-law got a raise for her retirement fund. It seems everyone is happier than before; except for the 20,000 yen for a M2 for their home or ten thousands contribution to enroll a child in school, or complaints off the lower income people with prices they paid, and my dollar went down to 6.2 yen. Congratulations, China.
      It was just a phenomenon in seeing the M2 went 97.4 trillion, or 188% of GDP. I and my brother in-law, a realtor made discussion on the price-asset bubble in Guangzhou’s real estate. He laughed at me for being naive for no knowing how wealthy the people are in China; but I reminded him of Zhongshan in 90s’ that abandoned building were everywhere after the 97’ financial crisis. I just cannot cut his euphoria or attitude in "Irrational Exuberance" as Alan Greenspan mentioned which later showed in the inequality of classes of wealthy people in America. We settled on the liquidity too even though the EU may broke up after Germany and England leave. China is still being at the first option for investment after the standardized IPO and tighter central controls on the local debt growth.
      I think inflation and valuation can come later with China’s resolution on how centralized authority can be when balloon payments are demanding in the local establishments, or write offs in the takeovers. Besides, if the RMB is stepping forward to its international reserves currency, the exchange rate or interaction on the foreign diplomacy could be the next concern that would cut its liquidity with its out flow. Perhaps, if there are cases like the “ClubMed” occurs, can China stripe its liabilities off like Goldman Sacks in time? I wonder.
      However, I really like the last paragraph implicating the policy on the relationship between currency and finance is essential to ensuring that all newly issued currency is backed by assets and its constraints. It is because I learn well off the “irrational exuberance”. It seems I can find one to resonate rather than finding I just being pessimistic or worrying too much. Keep up the good work.
      May the Buddha bless you?

    2. CommentedFrank O'Callaghan

      The increasing trend in China for the State to cede power and wealth to a tiny protected elite goes on. The fear of an urbanized unemployed revolution underlies this.

      The technical discussion of the money supply disguises the relationship in China between production, consumption, distribution and investment.

    3. CommentedProcyon Mukherjee

      An excellent article with a lot of information and if we are discussing financial deepening then China has surpassed all the developed world quite surprisingly, but all for good reasons. Financial depth, approximated by private credit to GDP, has a strong statistical link to long-term economic growth; it is also closely linked to poverty reduction. China’s size of the economy is growing at close to $900 Billion in PPP terms every year compared to $350 Billion for U.S. This needs a growth in M2, which would be quite disproportionate as China does not enjoy the market based nature of financial markets as in U.S.