My students can't afford a subscription to the Wall Street Journal and they asked me to post the Op Ed piece I wrote in today’s paper. Here it is:
For all the energy U.S. and European politicians have exerted pressing Beijing over the yuan, internal economic problems are the greater concern for Chinese policymakers. And whether or not Beijing realizes it, a policy move last week to clamp down on bank lending may hasten the day when China is forced to revalue its currency.
China’s financial authorities face two contradictory policy demands. They need to rein in out-of-control growth before it sparks rampant inflation. They also need to maximize job creation to avert social unrest that might stem from growing income inequality. And they are running out of policy tools.
Beijing has tried for at least three years to moderate growth, but with minimal success. In 2007 alone, the People’s Bank of China (PBoC), China’s central bank, raised its benchmark loan rate five times, to 7.29%. It also raised the minimum required capital reserve for commercial banks nine times, to 13.5%, the highest level in the PBoC’s history. Administrative measures have been introduced to limit bank lending, reduce price subsidies, redirect investment, and talk down speculative and investment activity. Last week, Beijing rolled out its next-to-last big gun, a Draconian administrative cap on new credit.
Still, GDP growth this year is expected to hit 11.6%, well above the already high 10% forecasts at the beginning of the year, and the fifth consecutive year of double-digit growth. Inflation has risen steadily to 6.5% in October from 2.2% in January, and there are reasons to believe that next year inflation might get worse. Most of the other warning indicators — expansion of the money supply, credit growth, speculative activity in the local stock and bond markets, increases in fixed asset investment and industrial production — are well above official targets.
Earlier measures have failed because they have skirted the underlying reason for China’s problem: its currency regime. Because the PBoC rigidly fixes the foreign exchange value of the yuan within a narrow trading band, it has lost control of domestic monetary policy. China’s money supply is determined primarily by the net inflow of foreign exchange on its capital and current account. Because the value of the yuan is set so low, China runs a large trade surplus, whose magnitude is further exacerbated by large amounts of foreign direct investment and speculative inflows.
These large inflows must be converted by the PBoC into local currency or central bank bills, so that the fantastic rise in China’s foreign reserves is matched by an equally large rise in its domestic money supply. As the money supply surges, it encourages massive increases in fixed asset investment (up 27% so far this year), which in turn causes industrial production to surge. Since China cannot consume as fast as it produces, the balance must be exported, thus forcing ever greater trade surpluses and locking the country into a self-reinforcing cycle of monetary excess. Until this mechanism is broken there is little China can do to control its economic overheating.
Beijing is still reluctant to consider a dramatic revaluation. Instead, last week’s meeting of the Central Economic Work Conference, an annual meeting of key policymakers, recommended a sharp clamp-down on credit growth. Banks will reportedly be permitted to increase their total loan portfolios next year only by an amount equal to this year’s lending increase. This is expected to bring loan growth down to 13% next year from 15% in 2007.
Caps on loan growth have failed before, thanks to lax enforcement, although most reports suggest that this time authorities are far more determined. Whether that is likely to happen during the run-up to the Olympics remains to be seen, but there is reason to believe that even if the authorities were successful, loan caps would have only a minimum impact on moderating underlying conditions. The measure would only force excess monetary expansion into other conduits for funding rapid economic growth.
Domestic measures to slow the consequences of monetary expansion will not work if the underlying monetary expansion continues unabated. The newly proposed curbs on Chinese credit growth, if they are effective, are only likely to fuel growth in the local stock and bond markets and to push money into the informal banking sector, where conditions are flexible and restrictions ignored.
The outcome of last week’s Beijing conference suggests a shift in the balance of power away from those determined to maximize employment growth and toward those concerned about the dangers of monetary excess. But the credit clamp-down suggests Beijing still hopes to address China’s economic imbalances without touching the currency regime. If and when last week’s measure fails to produce the desired results, the need for yuan revaluation will come even more sharply into focus.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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December, 2007
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