ATLANTA — Chinese monetary authorities raised their one-year benchmark rate by 27 basis points while allowing the deposit rate to remain unchanged at 2.25 percent. This move was mostly greeted with praise, but the change is trivial and will have little discernible impact on the Chinese economy or the global economy.
Since China’s financial system remains underdeveloped, the economy is less sensitive to changes in interest rates. Authorities rely on other crude levers, including tinkering with foreign exchange rates and jawboning. But these have had little effect. It turns out that the interest rate hike did little to slow down yuan-denominated bank lending, as local-currency loans surged 16 percent in May.
And according to recent central bank data, the “M2” measure of the money supply increased by over 19 percent in May, year on year, the fastest growth in two years. And the rate of growth of M2 rose in April by 18.9 percent from a year earlier compared with 18.8 percent in March.
M2 includes cash and all deposits circulating in the financial system. Its growth is seen as an indicator of the risks of rising consumer prices and wages. As it is, China’s money supply is expanding about twice as fast as is the overall economy.
In response, Beijing has told state-owned banks to halt “excessive” investment and credit activity. With China’s economy, especially the property market, expanding more rapidly than planned, interest rates are likely to be raised in response to incipient signs of inflation.
Alas, despite all the material advances in China’s economy, authorities in Beijing are woefully inept in terms of understanding basic economic principles. It turns out that the most important element in the determination of exchange rates and domestic prices is the pace of money expansion relative to real economic growth. It turns out that a flood of global liquidity into China, and Beijing’s unwillingness to stem the flood of liquidity into the domestic economy, is behind a global commodity bubble.
Were China to allow the value of its currency to appreciate without changing its loose monetary policy, its overall demand for commodities would rise.
As it is, massive purchases of dollar-priced commodities by China have been a significant factor behind the overvaluation of some goods and services priced in dollars. Since China cannot print dollars, it cannot cause the prices of all goods and services priced in U.S. dollars to rise. But it can cause the prices of some goods to rise relative to others.
China’s problems are not limited to rising prices of industrial commodities. Most of the problems come from its ill-fated export-led growth policies, which lead to the manipulation of foreign-exchange rates.
As foreign currency flows into China, the central bank buys it from the commercial banks in exchange for yuan in order to keep the yuan from rising too quickly. And then to stop funds from entering the economy too rapidly, extra liquidity is mopped up by issuing treasury bills to financial institutions, a policy known as sterilization.
These moves are guided by an ill-advised adherence to neo-mercantilist policies that inspire an unhealthy dependency upon exports as the basis of economic growth. As such, the export-oriented growth policy determines exchange-rate and monetary policy.
China’s loose monetary policy and rigid exchange rate is partially behind the continued rise in global commodity prices. The fundamental cause is the excess global liquidity created principally by the U.S. Federal Reserve system and other central banks that have kept interest artificially-low for so long.
China faces numerous domestic challenges, including inflated property prices, erratic valuations on local stock markets, and an over-reliance upon exports for economic growth. There has been an explosive growth in bank lending. Beijing’s official target for new yuan loans for all of 2006 is 2.5 trillion yuan, but loans worth about 1.26 trillion were already booked during the first quarter of the year. With no change in deposit rates, higher lending margins are likely to induce banks to expand credit since most derive over 90 percent of their revenues from the spread.
If Chinese banks push the excess domestic liquidity into potentially unprofitable projects, nonperforming loans will increase along as will excess productive capacity. While the amount of bad loans at China’s banks is officially set at $162 billion, nonofficial figures place it much higher. (Ernst & Young withdrew its estimate that China’s total liabilities for nonperforming loans were more than $900 billion — higher than its $875 billion of foreign reserves.)
All this takes place within a weak financial sector that suffers from poor assessment of credit risk and vast numbers of overstaffed branches with weak central control. And then the central bank is guided by policy considerations rather than economic rationality.
Despite an impressive stock of reserves, second only to Japan’s, tightening of global-liquidity conditions will cause China’s reserves to shrink. China’s liquidity problems will not require an absolute decrease in export demand — something that is unlikely anyway.
The problems will be triggered when the rate of increase in demand slackens. For example, expanded capacity based upon an expected sales increase of 10 percent that turns out to be an increase of only 5 percent will lead to excess capacity and layoffs.
And so it is that a poor understanding of the relationship between monetary growth and the condition of the economy by China’s policymakers have created a boom-and-bust cycle.
The joys of China’s boom are well chronicled. Alas, the bust will have serious political consequences for the authorities in Beijing and create economic problems for much of the rest of the world.
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