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| China should tighten to loosen | | Print | |
| Nov/Dec 2008 | |||
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Raising interest rates - not lowering them - is the key to growth in China writes Macquarie's China Economics head, Paul Cavey. China's economy is facing what looks to be its biggest test since 1978. With the two major economic engines of growth, exports and real estate construction, both stalling, the economy risks its first simultaneous downturn of external and domestic demand growth since 1996. This is understandably leading to huge pressure for policy easing, and Beijing has already yielded by stalling RMB appreciation and cutting interest rates. This is wrong-footed. Certainly we would hope to see some measures to support growth. But this loosening should come in the form of aggressive interest rate hikes. The reason is China's cyclical problems are exacerbated by big structural ones, mainly that after 30 years of reform the most important price in the economy - the price of money - is still controlled. Calls for appreciation of the Renminbi have clearly been loud. While often motivated more from a perception of US national interest, there have also been claims that appreciation would help China. The reason is the tremendous build-up of foreign exchange reserves that is the surest sign of undervaluation. To prevent exacerbating this inflow further, the authorities have kept interest rates low. The combination is a classic recipe for a bubble. The liquidity creates the excess supply of credit, and the low rates the demand. In reality, it is hard to find evidence of a credit bubble. Take bank lending growth of around 16 percent a year. Thus, while growing quickly in absolute terms, the stock of outstanding credit has actually fallen relative to the size of the economy, from 125 percent of GDP in 2003 to around parity now. This compares with the US, where in the same period, credit has ballooned to almost 180 percent of GDP - and this not even including the liabilities of the superleveraged financial sector. So contrary to expectations of an unsustainable credit bubble, it looks like bank lending in China has been only just enough to grease the wheels of the rapidly growing economy. The reason is China's banking sector has been effectively held in a straightjacket. The banks have been ordered not to lend, instructions which in particular this year have been backed up with sterilisation, the process by which the central bank uses reserve requirements and sales of central bank bills to soak up excess Renminbi and stop the banks from lending. This has been a process on an epic scale. Altogether, the stock of sterilisation instruments on the balance sheet of the People's Bank of China is now worth more than US$1.8 trillion. This is a sum of money equivalent to the combined annual GDP of Africa and the Middle East, and three times the bail out package in the US. It is also equivalent to four years' bank lending in China, and five years property sales. On our estimates, real growth in China has been around 15 percent in recent years. Think how crazily fast it would have been if the banks had been allowed almost US$2 trillion more to play with. Credit bubbles are hugely damaging, for the financial sector specifically, but for just about everybody else too. So China's banking straightjacket has certainly been useful, protecting the banks from themselves and the economy from the banks. Given the chaos everywhere else, it is tempting to think that wider acceptance of what might be termed the Beijing consensus - loose monetary policy and over-bearing banking regulation - would have saved us from the pain of the Washington one - loose monetary policy and seemingly no regulation at all. Tempting perhaps, but premature. The problem is just as real straightjackets are designed for restraint not treatment, so China's metaphorical one is preventing the banks developing the risk management and other skills needed to make them self-supporting commercial institutions. China's straightjacket is a second-best policy. A much better approach would have been to deal directly with the low cost of money. And this is why it is so important for Beijing not to start cutting interest rates, but actually to raise them to replace sterilisation, to allow credit growth to be managed through price rather than administrative restrictions. Only in this way will China's banks begin to learn how to judge risk, and thus to wean themselves away from state-owned enterprises, and start lending more to the masses of small and medium-sized enterprises. Most evidence suggests it is the small private firms which are the most productive in China, and as in other economies, are also the most employment-intensive. But their development is stunted, because credit rationing denies them money from the banks. Instead, they are pushed to the informal credit market, the existence of which is a mixed blessing: it certainly augments official credit growth, but with interest rates of perhaps 40 percent, it is hardly a worrying source of cheap finance. It is this comparison that suggests China really does have room to raise formal interest rates: even a borrowing rate of 15 percent would be low for the army of SMEs. It is easy to be critical of US-style financial reform tight now. But while the US seems to have been one extreme, with the price of money just about the only thing that mattered, China is at the other, with regulation all important. While the freedom of the first bred terrible over-leverage, the moddy-coddling of the second is preventing the emergence of the kind of free-standing banks and productive companies necessary to support economic growth in China as exports slow. So while the market is likely to applaud Beijing in the next few months for cutting reserve requirements and interest rates, we would advise more circumspection. To loosen policy what China actually needs is money that is more expensive, not cheaper. ■ *Paul Cavey is Macquarie Capital Securities' head of China Economics and is based in Hong Kong.
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