The PBOC’s misstep on monetary policy
Ben Bernanke’s Federal Reserve pumped a US stock market recovery after 2008 by pushing real short-term rates well below zero. The strategy was based on a standard interpretation of the Keynesian model that plays on modern portfolio theory. It bets that if the real yield on cash goes negative (and real term yields are barely positive), investors will switch from cash and safe bonds into risky assets.
Unfortunately, the Peoples’ Bank of China is yet to grasp this point.
China’s real yields, in comparison, are the highest among the world’s major economies. As a result, China’s real effective change rate has risen by almost 60% since 2009.
That’s thrown a spanner in China’s export growth. On the upside, Chinese industrial profits are managing to keep their head above water despite interest-rate riptides. As Reorient Financial Markets analyst Victor Kwan pointed out in a July 27 research note, “Assuming a conservative RMB 10 bn investment loss in June vs. last year, core industrial profits grew by 1.4% y-o-y last month. That is an improvement from May’s comparable figure of -1.3% y-o-y and April’s 0.1% y-o-y.”
The other point to remember is that China’s fundamentals remain intact. At 7% GDP growth, China’s economy will double in 10 years; at 5% growth, it will double in 14 years. Even with a now much-publicized slowdown, this would make China’s economy the envy of all advanced nations. With H-shares trading at 9 times earnings, Chinese profit growth is also the world’s best long-term bargain.
Sadly, China’s central bank and stock market regulators tried to have the best of both worlds: They kept real interest rates high, targeting the yuan’s parity with a soaring dollar, while driving credit growth at high real interest rates.
A disproportionate share of the credit growth funded stock buying on credit. From the look of it, margin financing at brokerages was just a small part of overall financing, and the unwinding of leveraged positions will take time to run its course.
As Asia Unhedged said earlier, the right move would have been to emulate western central banks and sharply reduce real interest rates. This would have given up a peg to the US currency that is no longer useful, and which has become a liability. Having regulators jump into the market to stem a crisis makes perfect sense, but only when monetary policy is in step with reality.