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China’s Liquidity Paradox

BEIJING – 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, at root, 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 United States, with an M2/GDP ratio of about 200%, compared to about 80% 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 150% of GDP. But, since 2008, credit expansion has proceeded at a staggering pace, driving the debt/GDP ratio above 200%, with private credit alone (including to state-owned enterprises) amounting to 130% 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 renminbi credit report, the People’s Bank of China’s foreign-exchange reserves climbed to ¥27.5 trillion ($4.5 trillion) in September, up ¥126.3 billion 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, reflecting a monthly increase of almost ¥170 billion.