Taking Away the Ladle: China’s Exit Strategy for Monetary Policy

A Summary of Remarks by
Dr. Mark A. DeWeaver
Quantrarian Capital Management
April 8, 2010

Dr. Mark A. DeWeaver spoke at the National Economists Club luncheon on 8 April 2010 on “Taking Away the Ladle:  China’s Exit Strategy for Monetary Policy.”  Taking away the ladle referred to using administrative measures to cut-off access to credit, as opposed to the Fed’s traditional method of taking away the punch bowl by raising interest rates. 

“Taking away the ladle” cuts off entire classes of borrowers (such as developers), regardless of their individual merits, as opposed to conventional interest rate policy, which allows market forces to determine which projects are halted.  The private sector would have to do the investing with interest rate adjustments.

In China, counter-cyclical enforcement of prudential bank sector supervision must serve as a substitute for normal central bank tightening and easing cycles.  Tightening of the prudential supervision in 2010 was correcting the extraordinary expansion.  For seventy largest cities, loan growth decreased in 2010 from a peak of approximately 35% loan growth in 2009; the official fiscal deficit was only 2%.  Prior to 2009, loan growth was 25%.  25% of the 2009 new lending may have gone into the property market.  The height of the housing bubble was at the end of 2007.

Laws in China prohibit direct borrowing by local governments, but they have gotten around this through setting-up local financing platforms.  Local governments also typically issue a “letter of comfort” to lenders, which states that the repayment of a loan will be prioritized in allocation of future proceeds of future land sales.  Land sales are the ideal way to pay loans.  There is some question as to whether these letters would be considered invalid by Chinese law.  70% of local financing platforms are thought to be unprofitable.  These platforms are primarily backed by local government law holdings.  3800 of these platforms have borrowed over 240% of total local government annual revenue.  Many of these investments include excess capacity or are in “redundant infrastructure projects,” or involve projects that do not generate revenue such as repairing bridges and roads.  “Investment platforms accounted for 40% of new lending in 2009,” Dr. DeWeaver stated.  Effectively, the growth rate of the investment platforms in 2009 was 273%.  The share of total new lending of the 2009 increase in total CNY loans was 40%.

While there are four monetary approaches, “windows guidance” and “administrative measures” are the most effective in China, even prior to 1978.  These measures include “verbal directives, periodic circulars, and regulatory changes.”  Other monetary approaches include base rates for deposits and loans, required reserve rates, and open market operations.

The importance of sterilization (removing local currency created by converting forex inflows) of currency arises when there is an increasing differential of raising interest rates and currency increases.  An example of the process is as follows.  Exchange the currency, where the foreign and local interest rate spread is created.  Convert dollars into yuan, while taking away relatively higher interest rates for corporate.  The exchange rate cannot adjust.  There is no adjustment for surplus dollars demanded.  Dollars are brought to the Chinese central bank.  China has to issue yuan for dollars, which increases the money supply.  The result is the undoing of the tightening affect with the interest rate affect.
There were three occasions since the mid-1980s, where the People’s Bank of China raised interest rates in early-to-mid 1989 and mid 1993 (“Draconian credit controls”) and in the Fall of 2007 (the global financial crisis).  The CPI was greater than 20%; the inflation rate increased from 5.1% to 8%.

Between 2004 and 2008, Chinese net exports of goods and services rose approximately six times.  In 2009, the sterilizing forex inflows (with required reserve rate increases) increased by 100 basis points.  Overall, PBOC forex reserves and matching liabilities had the following changes between January 2005 and December 2009:  required reserve – from 38% to 57% of total forex reserves, CBP (central bank paper) and repos (repurchase agreements) – from 22% to 28%, residual – from 40% to 15%.  Local liabilities translated into foreign assets.

The three-year central bank paper had been suspended in 2008 and started selling again, thereby, removing the currency.  In China, the outstanding amount of central bank paper and repurchase agreements has been up and down within a range.  Since the Fall of 2008, the average time to depreciation has substantially declined since 6 June 2008.

The majority of investments in China involved “soft credit constraints.”  Two-thirds of the 2008 fixed asset investment was directly or indirectly owned by the state; 36% was partially state-owned and 28% was state-owned.

The “main targets of administrative tightening” are local financing platforms, mortgage financing, property development, and personal loans.  Existing lines of credit are being cancelled.  Some banks are temporarily suspending mortgage financing completely.  There has been suspension of lending to over-leveraged projects for all borrowers.  There have been investigations into flows of personal loans into the stock market.  Some of the bank branches involved was ordered to halt personal lending for the next six months.

China has a “command economy” versus a market economy.  For controlling credit growth, the Chinese monetary authorities are employing five main strategies:  Due diligence should be done in the careful monitoring of payments and their purposes.  Differentiating the required reserve rate and interest rates would be of importance.  Impose strict enforcement of the bank capital adequacy requirement.  Enforce the loan guarantee law with restraint.  Reduce lending to quarterly.

History has repeated itself.  Between 1972 and 1973, “centralized economic management (was) reintroduced,” and “enterprise working capital to finance infrastructure construction (was) prohibited.”  Between 1985 and 1986, “restrictions (were) placed on projects outside the state plan and on minimum capital requirements for borrowing by township enterprises.”  Between 1993 and 1994, “mortgage lending (was) suspended, financing projects (were) withdrawn, (and there were) investigations into the misappropriations of state funds.”  In 2004, (there was a) reduction in new project approvals and financing curbs for sectors with excess capacity, (and there were) restrictions on land supply.”

Points made during Q&A are as follows.

In regard to monetary versus fiscal policy sustainability, the official fiscal 2% of GDP depends on what contingent liabilities are included.  “Chinese consumers have low returns on savings at banks with higher taxes.  Banks are flush with deposits.  Local depositors know they will get their money back.”

Japan in the 1980s rebalanced export and investments with difficulty.  Because of a subsidy, the spread widened between the deposit rate and the loan rate.  There really is not a direct fiscal exchange.  There were serious problems for economic growth in the long-term and for investment growth.  The growth should have been realized by now.  The consumer took the burden and thus, growth was unsustainable.  Japan in the 1990s had “zombie” banks, but they kept going.

State-owned enterprises are large savers.  There are a large number of small savers and these savers are generally not stock market investors.  Money and shares are just different types of deposits.

Rural credit cooperatives can lend at double the base rate versus bank-to-bank.  Special regulations can increase the affect.

While there can be arbitrage between shadow banking and formal banking, China periodically cracks down on sources of credit for short periods of time.

It is too late for an easy solution related to the currency challenges, because the net inflow of trade surplus and foreign trade investment has grown to be sizeable.

Mark DeWeaver worked as an analyst at W.I. Carr (Hong Kong) from 1991 to 1992 and later for Peregrine Brokerage, from 1993 to 1995.  While at Peregrine, he established the company’s representative office in Shenzhen, China, analyzed “B” share companies in the property and retail sectors, and wrote a monthly research note, “Letter from China,” that analyzed the China-based activities of Hong Kong-listed companies.  From 1995 to 1998, he attended the University of Hawaii, where he received an East-West Center grant and was awarded a Ph.D. in economics.

Rapporteur:  Renee DeFore

 

 

 

 

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