2011-07-04 / Andy Xie
The so-called money shortage today reflects excessive money demand in the past, which was a result of very loose monetary policy. If the tightening policy is changed due to the pressure, the monetary condition would go back to the excessively loose state. As inflation is still unstable, i.e., product or service price could jump by 20-30% in one go, loosening monetary policy could trigger hyperinflation and social turmoils.
There is a need to switch the tightening policy towards raising interest rate from just increasing bank deposit reserve ratio. The later only shifts interest rate increase into the gray market, which disproportionately burdens the SME sector. The current tightening approach protects local governments and SoEs that were the main drivers of the rampant money demand. Spreading the adjustment pressure through interest rate policy will help China achieve soft landing.
Liquidity tightness is necessary for controlling inflation
Monetary tightening inevitably leads to the feeling of money shortage in the short term. Otherwise, the tightening cannot be effective. The tightening is caused by inflation. If nobody spends less, i.e., nobody feels liquidity pressure, how could tightening achieve its goal?
How could the tight feeling go away? The prevailing view in China is that the central government needs to loosen up. This is very wrong. When the businesses that shouldn't borrow and spend leave the scene, the tight feeling goes away. When a fat person goes on a diet, the hungry feeling goes away when the stomach becomes smaller due to a period of controlled diet. If the hungry feeling goes away with eating more, how could dieting work?
China's M2 is growing at about 16%. It is still high relative to China's potential growth rate. When an economy has low financial depth, i.e., low ratio of financial asset value to GDP, M2 could grow much quicker than GDP. But, China's non-financial sector indebtedness to financial corporations was Rmb 72.7 trillion in April or 182% of 2010 GDP. Fitch estimates that China banking system has off balance assets equivalent to 25% of its total. China's gray financing market could be another 25%. It is fair to say that China's non-financial sector has debts above 200% of GDP. This level of indebtedness is unprecedented for a country with $5,000 per capita income. So China has no excuse to grow money faster because the country has low financial depth.
As China's population ages, the potential growth rate is likely to trend from the current 10% to 5% by 2020. If China's M2 grows at 10% in 2020, the inflation rate would be 5%. So the 16% today isn't low. It feels tight because lots of borrowers should exit. Unless it happens, China's inflation couldn't get under control.
Inflation isn't under control yet
China's inflation picture remains unstable. When the price of a product or service rises, it often goes up by 20 or 30%. This is rare in a normal inflationary environment in which prices tend to rise in line with CPI. The reason is because the stock of money supply is turning into inflation. China doubled its M2 in the past four years on top of an inflationary economy.
The government is taking some administrative measures to cool inflation. Cutting highway tolls, decreasing import tariffs, and jawboning businesses from raising prices could cool inflationary pressure for the time being. But, these measures only delay, not reverse the trend. If one interprets any cooling from such measures as victory over inflation and begins to loosen up again, a catastrophe will follow.
When someone has fever, ice could cool the temperature. If a doctor declares the patient cured, the patient's disease won't be treated. The problem will only get worse.
China isn't in a shape to loosen monetary policy whatsoever.
Some argue that China's inflation is only in food and energy, i.e., inflation is due to localized supply and demand balance, not loose monetary policy. This is very wrong. Services are inflating across the board. Even barber shops at street corners are raising prices. Rents are rising at double digit rate.
Lack of accurate data hampers the debate on inflation. If the statistics are not accurate, how could we have a meaningful debate? It would be catastrophic to declare victory by pointing at faulty data. Such a gesture will scare people into full panic.
The tightening mix should change
The tightening so far relies on quantity restriction through increasing deposit reserve ratio. The interest rate hikes have been marginal. Hence, the demand for credit at the current interest rate exceeds supply. The imbalance is kept at bay through limiting credit access. The non-state sector has a tougher time to borrow than before. It leads to skyrocketing interest rates in the gray market. Hence, the non-state sector bears a disproportionate share of the tightening consequence.
The supply-demand imbalance has allowed the banks to raise lending rate too. The banks could increase lending rate by 30% above the policy rates. Further, through charging advisory fees and forced deposit back, banks can charge a lot more, even to the state owned enterprises.
China's tightening mix sacrifices savers. China's household sector has Rmb33 trillion in bank deposit. The current deposit rate is at least three percentage points too low, compared to the effective lending rate or inflation rate. The household sector is effectively subsidizing debtors, mostly SoEs and local governments, to the tune of over Rmb1 trillion per annum. It is equivalent to half of the total SoE profits in 2010.
The low interest rate policy isn't costless to the government. It keeps inflation expectation high and unstable. Chinese businesses used to be known for price competition. Increasing price at any excuse seems to become common. Of course, the low deposit rate keeps the household sector jittery, which makes the business strategy of increasing price more likely to succeed. It makes fighting inflation more difficult.
China should switch from relying on increasing deposit reserve ratio to increasing interest rate to contain inflation. The former is unfair to the private sector, making life difficult for SMEs and decreasing household wealth.
Don't exaggerate SME problem
Lately, many people have suddenly become very caring towards SMEs. The story goes like this: the tightening is causing SMEs to go bankrupt, which could cause an employment crisis. Neither description is correct. SMEs always have financing problems. The same people didn't pay much attention to them before. The purpose of the SME talk is to pressure the central government to loosen up, which would mostly channel money to local governments and property market, not SMEs.
The talk that SMEs are going bankrupt because of the tightening isn't logical at all. Like big companies, SMEs are supposed to be profitable. If they can't get new loans, they can stay with their current businesses and postpone expansion. If the SMEs are going bankrupt because of no new loans, it means they don't make money and stay in business by borrowing more and more. Does it make sense to keep such businesses alive? They will only become bigger problems down the road.
Unfortunately, some SMEs that are going under precisely fall into this category. In the past three years, many coastal private enterprises have switched from manufacturing to financial speculation. Their manufacturing assets have become financing vehicles. The borrowed money has gone into silver, copper, or stock market. The recent declines of such assets have caused havoc among such businesses. Should the government be responsible for bailing out financial speculators?
SME's always have difficulties in raising financing. Every country talks about helping SMEs. But, SMEs always face higher cost of capital. In the end, size does matter in risk. Ceteris paribus, a small company is riskier and must accept higher cost of capital.
As discussed above, China's method of tightening is causing more harm to the SME sector. By limiting credit supply to SoEs and local governments, SMEs face extremely high interest rate in the gray market. To help SMEs, the government should shift to increasing interest rate and opening credit access to anyone who is worthy.
Talking about employment crisis is just a scare tactic. China has manual labor shortage. The coastal export companies that have moved inland have found labor shortage there. China's demographics has changed. There is no endless supply of cheap labor anymore. Three decades of one-child policy is having a big impact on China's labor market. Even if some SMEs go bankrupt, China wouldn't face an employment crisis like a decade ago.
China does have an employment problem with college graduates. But, pushing growth under the existing model wouldn't solve it. The current growth model favors blue collar jobs, because construction and manufacturing always lead. To create more jobs for college graduates, China needs to become more consumption and service oriented. It requires structural reforms, not loose monetary policy.
Inflation is causing social instability
China's nominal GDP doubled between 2006-2010. The living standard for most people appears to have not risen and has fallen for a considerable portion of the population. As a result mass protests, especially the violent ones, have increased. Pushing growth under the current economic model will only increase social instability.
The benefits from economic growth to the masses are jobs and purchasing power. China is facing manual labor shortage even in central and western provinces. With manual labor shortage, growth isn't important for the first part. It is negative for the second part, as inflation has been higher than wage increase for many people.
Inflation is very negative for household wealth. People save for a rainy day. But, when inflation erodes the value of one's deposit, one's insecurity rises immensely. When wages are not kept up with inflation either, violent social protests are quite likely.
The wrong kind of growth
GDP growth has become a religion in China. It is automatically assumed to be good. The reality is different. The current growth model channels money to local governments through property market, fees and taxes. The local governments spend the money on projects that they think worthwhile. The money trickles down to the household sector through such projects. But, before the money reaches workers, most are taken away by the middlemen. This is why most people don't feel better off in the past four years even though the nominal GDP has doubled.
Property and food are two areas where people feel hit hardest. When property price is twenty times household annual income, life cannot be that good. One doesn't feel much better when the salary rises by 10 or 20%. It wouldn't make a big difference. The high property price has killed the hope of China's middle class, all for raising revenues for local governments. Could their projects be as important as 1.3 billion people's happiness?
The food safety crisis should be viewed in the context of government squeezing the household sector. The people at the bottom have seen their savings inflated away and income not rising in line with food price. The industry lowers the price to their income level through illegal means. From raw materials like pork and milk to processed foods like bottled water and restaurant meals, the crisis touches most people in the country. It is possibly the single biggest risk to China's social stability.
Inflation is a consequence of China's growth model. It has reached its limits. When money supply rises, it causes asset inflation, which worsens wealth and income inequality, and decreases living standard for most people. To loosen up monetary policy now, without inflation under control, it will cause more social turmoils.
The current growth model is resource intensive. Coal price has risen by over ten times in ten years, twice as fast as nominal GDP. The other resources like iron ore, etc., are similarly appraising twice as fast as China's nominal GDP. This headwind means that China is giving more and more of its growth to resource suppliers, leaving less and less for people. So if China keeps pushing the current growth model through loose monetary policy, more and more of the share from growth will go to other countries. Without changing the growth model, growth itself is just not beneficial to that many people in China anymore.
Now isn't the time to loosen up monetary policy. Instead, China should focus on changing the growth model to keep more of the growth benefit at home and distributed more evenly.
Monday, July 4, 2011
2011-07-04 / Andy Xie