China’s Monetary Policy

We finished off yesterday poo-poohing the idea that China’s monetary policy makers can do anything to halt China’s bust that follows its boom.

Before we explain why, check out the latest example of what happens when easy money saturates an economy. Dan Denning sent this article to our inbox early this morning. According to the report, wind – of indeterminate strength – blew part of the roof off Shanghai Airport’s Terminal 3.

The architect blamed shoddy construction, as you would. We’re guessing the construction company, if they’re still around, will be pointing the finger at the architect.

So, why are China’s monetary policy makers impotent in preventing the bust?

The simple answer is because everyone thinks they can. It’s the ‘prevailing wisdom’. To paraphrase Warren Buffett, such sentiment will neither prevail for long nor be wise.

Yesterday, Money Morning editor Kris Sayce sent us this clip from Barry Ritholtz’s Big Picture blog. It’s a Bloomberg interview with hedge fund manager Jim Chanos, who recently visited Hong Kong and Australia.

Chanos is a noted China naysayer. When asked how he felt about his bearish call after the trip, he said:

“I think we probably came back a little bit more bearish…Our concerns about what we saw in Australia: an economy clearly tied to China has hitched its wagon to the tail of the tiger. In terms of the general complacency, what we heard over and over from investors and clients and potential clients is, ‘yes, yes, there are some excesses, but the government will figure out a way. That the government is this all-knowing, omniscient basic entity that will not prevent me from losing money.”

Clearly, Chanos meant to say ‘will prevent me from losing money’.

This is the denial stage of a bubble bust. While China’s economy is clearly slowing, the consensus opinion is this is an engineered slowdown that will be expertly managed by China’s central planners.

One of the biggest misconceptions is that China can lower interest rates to ‘loosen’ its tight monetary policy. Here’s a newsflash. Policy is not tight at all.

According to a report from Fitch Ratings, issued a few months ago, China’s official and unofficial credit growth equalled a massive 40 per cent of GDP in 2009 and 2010. They estimate it will equate to 37 per cent of GDP in 2011.

To give you some perspective, in the year to September Australia’s credit growth was equivalent to around 5 per cent of GDP.

So to think that China’s monetary policy is ‘tight’ and a few tweaks of the interest rate lever will encourage another wave of borrowing and even greater credit growth is wishful thinking.

China’s monetary policy is not tight. Sure they have raised interest rates a few times to cool speculation but inflation has been on the rise too. This means REAL interest rates (which equals the nominal rate minus inflation) are already very low or even in negative territory.

One of the big myths about China’s apparent strength is the size of its foreign exchange reserves. At US$3.2 trillion dollars, many people mistakenly believe China can use this ‘war chest’ to spend its way out of trouble.

As Chanos correctly points out in his interview, what China hopers don’t realise is that there are liabilities that match the size of those assets.

Those liabilities are effectively reserves of the Chinese banking system. The explanation gets a little complicated, but this all comes back to China’s currency peg with the US dollar.

The US has run a very loose monetary policy for years. To maintain a fixed rate to the dollar, China’s central bank has had to print yuan to buy dollars. The freshly printed yuan (to the extent that they are not absorbed by the process of sterilisation) flow into the Chinese banking system. They are additional fuel to the fire that is (actually, was) the Chinese credit boom.

So selling the foreign exchange reserves is not really an option.

Can’t China just run up big fiscal deficits to prop the economy up? Maybe that is a short-term option. But China’s debt is much larger than most people think. Officially it’s around 35 per cent of GDP, according to the IMF. Unofficially it’s closer to 80 per cent.

This is a result of combining all the bad local government debt with the debt of various ministries (for example, the bankrupt Railways Ministry has debts equivalent to 5 per cent of GDP), which the central government will need to stand behind.

So while China can potentially run large budget deficits to offset the credit bust, its existing debt load is already quite high for a developing economy. China doesn’t really have the fiscal scope to do any major stimulus. It doesn’t mean they won’t try, but it will be difficult to pull off in size.

And don’t forget, with the currency peg China is still hostage to US monetary policy. Ben Bernanke hasn’t pulled the QEIII rabbit out of his hat yet but it will come at some stage. When it does, it will have an inflationary impact on China (just like QEII did) making it that much harder for China to manage its credit-induced slowdown.

As Dan Denning is fond of saying, the West is in a credit depression. From where we’re sitting, China looks like joining that unhappy bunch in 2012.

Greg Canavan,
for Markets and Money

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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