My Blog

July 10, 2008

THU 10 JUL

What is money growth in China? By Michael Pettis

After I posted yesterday’s entry, one reader (RebelEconomist) asked the following question:

 

You often say China's money supply is growing fast because of its currency policy. Surely, if this was the case, base money growth would be strong. In fact, it appears to be very weak (growing about the same rate - 11%ish - as REAL not nominal GDP). It appears that sterilisation is completely successful. What indicator do you look at that makes you worry?

 

Since I have seen a lot of RebelEconomist’s writings and know him to be very strong on monetary issues, I hesitate to tangle with him on the subject, but it is a completely fair question and one I figured I should deal with formally in its own entry.

 

1.        China has a very high money base as a share of GDP.  I don’t remember the number (I will look it up some other time), but it materially exceeds that of most other countries, including most other large developing countries.  Increases, therefore, are from a much larger base, and any initial excess is likely to be multiplied.

2.        China sterilizes money creation by the issuance of central bank bills.  These are, however, extremely liquid and too close a substitute for money for them to reduce underlying liquidity in any significant way.  Corporations and banks hold them as cash and small investors eagerly buy up any on offer.  For these reason I see them mainly as a substitute of slightly more liquid form of money with a slightly less liquid form.

3.        I am very uncomfortable with the distinction between demand deposits and saving deposits, including long-term CDs, in the Chinese banking system.  I say this because a few months ago I purchased a 2-year CD at China Merchants Bank, which after one month I needed to convert (about one-quarter of it) into cash.  I expected a lot of difficulty and a penalty payment for breaking the CD (there had been no change in nominal rates, by the way), but it took less than 30 minutes, which is a dizzying speed for any transaction in a Chinese bank, and there was absolutely no penalty.  My only “cost” was I had to forgo the higher CD interest rate on the portion I cashed, although I still received interest on that portion at the demand deposit rate.  I have been told by friends that this is perfectly normal, so it seems to me that there is no real distinction, as far as I can see, between a demand deposit and any other kind of longer-term deposit except that you get a higher interest rate for the latter.

4.        In general for reasons I discuss below I tend to be very wary of the value of aggregates in determining money supply changes, especially in a country whose financial system is changing as rapidly as that of China, and more especially in a country that has a currency regime instead of a domestic monetary policy, so I prefer to use “gross” indicators like central bank liabilities.  This comes from many years of Latin American experience, especially in a country like Argentina with its “Convertibility Law”, a form of a currency board.  As money flooded into Argentina in the 1990s, it seemed to experience all the things we associate with a liquidity bubble far more than the growth in most of the higher-powered aggregates would have implied.  For this reason if PBoC reserve accumulation soars, I automatically believe money supply is soaring.

5.        Finally, the proof is in the pudding.  If I were to ask you what some of the consequences of excess money growth might be, you would probably tell me: rising inflation, low real interest rates, systematic overinvestment, highly speculative stock and real estate (and perhaps art) markets, rapid credit extension, and so on.  We are experiencing all of these things in China.

 

In general I tend to be a little Mundellian (at least according to my reading of Mundell) on the subject of money.  I don’t really think of liquidity as an aggregate, but rather as a quality.  All assets have greater or lesser degrees of “money-ness” and this can change over time.  What we usually call “money” is simply the asset with the most amount of money-ness, and although it is not always easy to decide what to include in our definitions of money, this reflects in part the problem of money as a quality rather than a quantity.

 

Even “money” can change its money-ness.  For example, not very long ago US dollars were a much more important part of China’s money base than they are today because they were – from what I have been told by old-timers – much more actively used as a medium of exchange and as a retainer of value.  People in China still have dollars (for example I do) but they are not used for everyday purposes at all, and they are costly to convert, so their impact on underlying liquidity in China is much lower.  When I lived in Haiti, however, dollars and gourdes circulated equally freely in shops and businesses at a constant exchange rate ($1 was then worth 5 gourdes – this was many years ago) and so it was only right to consider both of them equally as parts of Haiti’s high power money supply.

 

When an asset becomes more liquid and its value easier to ascertain at any given time, it becomes more money-like and it increases the underlying liquidity of the system.  A highly liquid and very widely traded and valued asset contributes more to the money base than one less so.  This was part of what Alexander Hamilton realized when he agitated for the creation of a single US national debt to replace the thousands of individual pieces of debt incurred by states and military during and after the Revolution.  His belief – well borne out by subsequent events – was that if these various obligations were assumed by the US central government, restructured into a single, large and fungible security, and given specific money functions (they could be used to pay taxes, as bank capital, etc.) they would essentially provide the US with a badly needed money base. It seems that he was right.

 

Perhaps a better example might be one cited by Charles Kindleberger.  After the Franco-Prussian War the victorious Prussians imposed on the French a 5 billion franc indemnity – then equal to about 25% of French GDP or 2-1/2 times the annual government budget – which the French were nonetheless able to raise fairly easily via a massive bond offering organized, I believe, by the Rothschild banks.  Kindleberger argues that the bond issue and subsequent huge transfer of (mostly) gold to Prussia represented a significant increase in European money supply because the bond itself fulfilled the function of money given its tremendous liquidity, high quality, and very diverse investor base.  Europe didn’t simply see a transfer of money from France to Prussia, in other words; it saw the addition of new asset that was a fairly close substitute for money and so a net increase in the “money supply”.  Not coincidently perhaps, immediately afterwards until the series of crashes and banking collapses that began in 1873, Europe and the world experienced a speculative frenzy that extended across the globe (in fairness the speculative frenzy began before the Franco-Prussian indemnity, but it reached its insane peak during and after).

 

When I lived in NY I used to discuss this often with the late Frank Fernandez, former Chief Economist at the SIA, and he often expressed his frustration at obtaining some reasonably reliable measure of global or domestic liquidity.  His conclusion, finally, was that there were no aggregates worth measuring.  In the end the best thing to measure was what he called the “shadow” of liquidity – such things as credit spreads, off-the-run Treasury spreads, bid-offer spreads for the most liquid assets, and so on.  I think I have absorbed his skepticism about the value of monetary aggregates as an accurate or even useful (in some contexts) measure of underlying money, especially in an unstable and rapidly changing financial system.

 

THU 10 JUL

Lower export growth = higher chance of policy mistake By Michael Pettis

The stock market rally finally stopped today.  After trading up most of the day, by over 1%, the SSE Composite lost its legs in the last hour of the day to close at 2876, down 1.54% for the day.  I guess the main reason for the fall was the release of trade numbers, which suggest that export growth is slowing sharply.  The trade surplus for the month of June was $21.3 billion, compared with $20.2 billion in May and $26.9 billion in June 2007.  I suspect the real trade surplus would be even lower if there were some way to strip out speculative inflows hidden in the invoicing of trade transactions.  Here is what today’s Bloomberg says:

 

Overseas shipments grew 17.6 percent from a year earlier, the slowest pace in four months, after gaining 28.1 percent in May, the customs bureau said on its Web site today. That was less than the lowest estimate of 23 economists surveyed by Bloomberg News.

 

Predictably, this has caused renewed calls for a slowing down of RMB appreciation and a loosening of (what they still call) “tight” monetary conditions.  I won’t do the broken record routine and explain why I think this is a mistaken interpretation of the causes of the export slowdown (which has far more to do with a slowing global economy and rising wages in China, neither of which will be positively affected by looser monetary conditions) and is a potentially costly mistake, but I will say that it is going to be harder than ever for the monetary alarmists to maintain their already-weakening grip on policy.  My favorite source on the politics of Chinese finance is Victor Shih, a professor at Northwestern, and he has this to say on his blog:

 

What we see today is nothing new, and as my book points out, has occurred repeatedly in the past 20 years.  Even Li Yining's call for "acceptable inflation" is not new.  He made exactly the same argument in 1988 when inflation was nearly 30%.  The problem is that Hu Jintao now has many followers serving as provincial party secretaries, and they are lobbying Hu not to squeeze money supply so hard.  Thus, unlike a few years ago, when Hu supported Wen's inflation fighting effort, Wen now fights inflation alone.  I think this is a very dangerous situation for future inflation trends in China.