Chinese Prime Minister Wen Jiabao
has criticized the US
for not taking measures to halt the dollar's slide and
made it clear that China would not revalue the yuan
under pressure. "You must consider the impact on China's
economy and society and also the impact on the
region and the world," Wen said in Laos late Sunday on
the sidelines of the Association of Southeast Asian Nations (ASEAN) meet
when asked about pressures to change the yuan's
decade-old peg to the dollar. Wen also signaled that
speculation was too rife in the market at the moment to
make such a change.
The announcement was timely
as China stands at the crossroads of economic destiny,
the direction of which will determine if it will be the
latest victim of bankrupt neo-liberal ideology or the
sole survivor that manages to develop an effective
immunity from the deadly financial virus of dollar
hegemony that regularly assaults all economies. On a
strategic level, China, the most populous nation on
Earth, cannot possibly expect to develop toward
world-class living standards by exporting to a rich
minority of the world's population. The poor economies'
excessive dependence on export to the rich economies
under dollar hegemony will perpetuate the
maldistribution of wealth on a global scale and put
China permanently on the lower end of that scale.
For a small, rich segment of the world's
population to be the engine of growth for the entire
global economy by consuming the products made by a poor
majority is a formula of global financial imperialism.
Financial imperialism is an advanced stage of old-time
industrial imperialism. Nineteenth-century industrial
imperialism of the British model at least produced
industrialized products at the core out of raw material
from undeveloped colonies. Twenty-first-century finance
imperialism of the neo-liberal model uses financial
manipulation to make industrialized colonies produce
everything in exchange for fiat money in the form of
dollars.
Imperialism, now and then In
contrast to industrial imperialism under which the
imperialist economy exports value-added manufactured
products for gold, with which to finance more new modern
factories at home, the financial imperialist economy
imports value-added products from the colonies and pays
for them with fiat paper. The colonial economies now
export real wealth in the form of value-added products
and get paper in return. To make matters worse, under
dollar hegemony, the fiat paper currency, in the form of
dollars, can only be re-invested in the dollar economy,
not non-dollar exporting economies. Exporting for
dollars is merely shipping wealth out of the exporting
economy to the dollar economy. The dollar economy has
become the luxurious front office of the global economy.
Both forms of imperialism sustain favorable
trade terms with the colonies through political
coercion. A sustained trade deficit supported by
currency hegemony is the essence of finance imperialism.
Unlike producers in the industrialized core during
industrial imperialism, producers in the colonies under
finance imperialism do not get richer from producing.
They are locked into a low-wage sweatshop production
system so that global inflation can be contained to keep
an ever-expanding supply of fiat dollars valuable.
Credit is allotted through a central bank regime not to
the entrepreneurs who can keep wages rising, but to
those who can succeed in pushing wages down with
government blessings. The more dollars the Federal
Reserve releases, the lower world wages must fall to
prevent global inflation. The more the dollar economy
expands, the smaller the wage-to-price ratio in dollar
terms. Those economies that defy this iron law of low
wages under dollar hegemony are punished with financial
crises that drain their dollar reserves.
Dollar
hegemony renders domestic Keynesian demand management
inoperative. It is no longer economically necessary to
manage demand by raising wages even at the financial
core, since consumption can be maintained by lowering
prices of products produced at low-wage peripheries,
paid for by the wealth effect of dollar assets buoyed by
a rising tide of fiat dollars that the Fed can release
without limits and with no penalty or reckoning. Thus
under dollar hegemony, money takes on an additional
function as a confiscatory tax on wages, apart from the
conventional functions of store of value and medium of
exchange. This confiscatory role of money on wages works
across all national borders, spreading and perpetuating
poverty on the working class all over the entire globe.
Neo-liberal economists call it wage arbitrage natural to
finance market fundamentalism. They put forward the
argument that workers are not unjustly exploited by
imperialists or capitalists. The dismal fate of workers
under dollar hegemony, in a neo-Ricardian iron law of
wages, is the logical outcome of a Hayackian amoral
market scientism. The law of the financial jungle has
become the ideal of the capitalist civilization.
Thus socialist China can move toward a "socialist
market economy" without any sense of guilt of betraying
its socialist revolution, all in the name of neo-liberal
modernization. In the US, displaced workers blame
low-wage workers overseas, rather than dollar hegemony,
for the predictable fate for workers everywhere.
Domestic class conflict is transformed into
nationalistic feuds between workers in conflicting
national economies. Dollar hegemony prevents non-dollar
economies from developing their economies with sovereign
credit denominated in local currencies to finance full
employment and rising wages. Dollar hegemony, operating
through unregulated foreign exchange markets,
neutralizes the purchase power disparity between
economies and makes it profitable to outsource
high-paying jobs from the US.
China's
move toward market economy along neo-liberal lines
was originally intended to be a brief and temporary
program to kick-start its economy off the stagnation caused
by decades of hostile US containment and embargo,
made worse by domestic ultra-radical excesses typical of
a garrison state. But the temporary corrective
expediency turned into a permanent revisionist policy
that inevitably led to political instability. The
pressure exploded in the Tiananmen incident in 1989, a
decade after the launching of China's "temporary"
economic reform. Misled by biased Western media with an agenda
separate from the target, adverse international reaction
on Tiananmen reverberated around the world, causing
intense hostility toward socialist China, particularly
from the Western anti-communist left, whose members
denounced the Chinese government as being repressive of
democracy, ignoring the fact that the real culprit was a
policy drift toward market capitalism away from
socialist planning. The historical fact was that
Tiananmen began as a student mass movement to arrest the
erosion of socialism in China.
Domestically,
the real tragedy of Tiananmen was not the alleged
abortion of latent bourgeois democracy, as the Western
media tried to spin it. It was the ossification of a
brief transitory strategy of market liberalization in order
to build better socialism into a lasting policy
of permanently postponing socialist construction.
This policy is rationalized with all kind of
revisionist ideological mumbo-jumbo, such as China must first go
through a long capitalist stage before it can move onto
a socialist stage, and let some people get rich first.
The word "first" was then conveniently drop and the
slogan became: let some people get rich, period. Yet
there is solid evidence that China has successfully
leapfrogged into the space age without repeating the
costly experimentation of another century of the
sub-orbital aviation. It is then a puzzle why socialism
has to be postponed and wait for its gradual evolution
from a restoration of capitalism.
There is no logic
in insisting on repeating the mistakes of the capitalist
West by copying a bankrupt market system bent on
recurring self-destruction. Yet Margaret Thatcher's fanatic
TINA (there is no alternative) mantra is accepted
as the gospel of truth. Income disparity and wealth
maldistribution natural to market economies are celebrated
as necessary dynamos of prosperity. Economics,
unlike truth-respecting physics from which it pilfered
many theoretical concepts, tends to hang on to obsolete
ideas long proved dysfunctional by events with ever
more sophisticated rationalization. While Issac
Newton is now a relic in the history of physics, Adam
Smith is alive and well in the temples of economic
thought more than two centuries after his time. China,
after half a century of socialist revolutionary
struggle, also swallowed the neo-liberal propaganda that
only market capitalism can bring prosperity.
The Tiananmen tragedy The tragedy of
Tiananmen in 1989 is that it sounded the death knell of
socialist revolution and heralded the restoration of
capitalism in China. Tiananmen began as a backlash
grassroots political reaction to wholesale official
rejection of socialist principles and ideology. The
students at the beginning of the Tiananmen incident
protested against the ill effects of the introduction of
market fundamentalism in the Chinese economy. They
wanted to preserve full government financial support for
education, particularly generous socialist benefits for
students, and protested against high unemployment,
income inequality and widespread corruption associated
with the move toward market economy.
Such demands
at first received sympathetic hearings from the top
leadership. Alas, wholesome student sentiments were quickly
manipulated to turn intransigent by the US media at
the scene to cover the state visit of president Mikhail
Gorbachev of the USSR in its final stage of implosion,
taking on the form of counter-revolutionary demands
for political liberalization toward bourgeois democracy.
While the students were actually demanding more
government protection from the erosion of socialist rights
and privileges gained for them by their heroic parents,
the Western media distorted the student protests
as demands for free markets and bourgeois democracy.
Naive protesters were selectively featured by the
US media on global television to recite Abraham Lincoln's
Gettysburg Address in broken English, never mind that
the speakers obviously had no understanding of US
history and politics, let alone the statist and
interventionist context of Lincoln's inspiring words.
The leadership in the Communist Party of China
(CPC) at that historical moment was divided. While some
remained sympathetic to a student movement to preserve
socialism, others found it imperative to decisively
crush a manipulated political revolt against a socialist
government. In a fateful turn of tactics in the
aftermath of the resultant tragic violence, the CPC
leadership decided to preserve political control through
further market liberalization, thus forfeiting its
equalitarian socialist mandate in favor of authoritative
institutional economics based on administrative
intervention on free markets. A decade and a half after
Tiananmen, the CPC is now forced to officially
acknowledge the problem of the continued ability of the
CPC to govern effectively. The phrase zhi zheng neng
li ("governance capability") surfaced in
mid-September 2004, when the CPC Central Committee was
reported by The People's Daily as "discussing the
cultivation of the ruling party's governing competence".
The authoritative paper noted that it was the first time
during the 55 years of history after the new China was
founded that "the country's ruling elite considered how
to improve the party's governance ability at an annual
plenum of the central committee".
It is a
conceptual oxymoron for a communist party to govern a
market economy. Yet despite all the ideological,
strategic and tactic errors of the past three decades,
the CPC is far from being an irrelevant political
institution as it remains the only political
organization with the determination and ability to
preserve the territorial integrity and independent
sovereignty of China. The history of the Chinese economy
shows that most periods of prosperity in four millennia
had operated under the socialist principle of a
commonwealth of Great Harmony (Da-tong) as
opposed to the capitalist principle of petty bourgeoisie
(Xiao-kang). The realities of Chinese society
will soon turn the CPC back on its historic socialist
track and wake up its leadership from the fantasy that
only market capitalism can effectively mobilize the
masses for national construction. Market fundamentalism
will only lead China to fall again into its past dismal
fate under the Kuomintang, whose socialist path had been
diverted with the assassination on August 20, 1925, of
leftist leader Liao Zhong-kai after the death of Sun
Yat-sen, resulting in a bankrupt economy that provided
the socio-economic backdrop for continuing semi-colonial
exploitation by Western powers and the rise of the CPC
as a liberating force for national revival.
But
dollar hegemony injures not only the working class. Even
the comprador class of finance imperialism is also
periodically stripped of their ill-gained wealth by
recurring financial crises caused by dollar hegemony.
Still the multi-trillion dollar losses from the
recurring financial crises and bubble bursts of past
decades circling the globe did not all come from the
rich. Some of it came from the hard work for low pay of
the working poor, funneled to the rich through
structural systemic economic injustice disguised as
market forces. But most of it came from institutional
depositories of worker pensions. Young workers are being
forced to pay for the systemic losses of financial
crises through the loss of jobs and reduction of
benefits their parents once enjoyed. Retired workers are
also forced to pay for the systemic losses through
drastic shrinkage in the value of their retirement nest
eggs. The enviable workers' benefits won through
century-long struggles of labor organization in the
industrialized core have been swept away by
neo-liberalism in the name of competitiveness, while
workers in the emerging economies are deprived of the
minimum social progress their counterparts in the
advanced economies already won a century ago.
Under neo-liberalism, even if and when
the Chinese economy should finally catch up with the
US economy, which under dollar hegemony is in
theory equivalent to trying to catch up with one's own
shadow in a setting sun, what Chinese workers have waiting
for them at the end of the market fundamentalism rainbow
is not a pot of gold, but the same dismal fate facing
the US workers today, ie, to have their jobs outsourced
to another still-lower-wage economy. China's industrial
heartland will look like the rust belt in the US, where
high-pay factory jobs have disappeared to low-wage
economies and once-booming factories sold for scrap
metal.
Race to the bottom The result
will be a global economy of more severe overcapacity,
with wages too low and jobs too scarce to provide the
purchasing power to buy the products workers produce.
There was a time when a government printed money
recklessly and hyperinflation would follow. Now, under
dollar hegemony, when the US Federal Reserve prints
dollars, inflation is kept under control by outsourcing
high-wage jobs to low-wage economies while wealth
becomes increasingly concentrated. Neo-liberal
economists fail to understand that money is useless
unless broadly distributed and spent. Neo-liberal
monetary policies tend to inject liquidity only on the
supply side as investment, an obviously wrong target in
an overcapacity economy. Overcapacity is a direct
outcome of excess return on capital from regressively
low wage schemes. Liquidity should be injected to
support demand management, by providing full employment
with rising wages until overcapacity is eliminated.
Unregulated credit markets inevitably become failed
markets by directing credit where it is least
constructive.
In China, the 1995 Central Bank Law
granted the People's Bank of China (PBoC) central bank
status, changing it from its historical role of a
national bank in a planned economy. Central banking
insulates monetary policy from national economic policy
by prioritizing the preservation of the value of money
over the monetary needs of a sound national economy. The
ideological assumption asserts that a sound currency is
the sine qua non of a sound economy. It is an
assumption that is neither logically true nor
empirically supported. A global international finance
architecture based on an unregulated currency market
with full convertibility at market rates in the context
of universal central banking allows an increasingly
volatile foreign exchange market to facilitate the
instant cross-border ebb and flow of capital and debt.
This instant cross-border flow of funds can be
devastatingly destructive with little advance warning.
Central banking thus relies on domestic fiscal austerity
and monetary contraction imposed through high interest
rates to achieve its institutional mandate of
maintaining the exchange value of the local currency and
to prevent destabilizing fund outflow.
In
contrast, a national bank does not seek independence
from the government policy. National banking views
itself as in a supportive role of national economic
policy. Independence of central banks is a euphemism for
a shift from institutional loyalty to economic
nationalism toward institutional loyalty to the smooth
functioning of a globalized international financial
architecture. The international finance architecture at
this moment in history is dominated by dollar hegemony,
which can be simply defined as a fiat dollar's
unjustified status as a global reserve currency.
National banking then seeks insulation and independence
from the international finance architecture dominated by
dollar hegemony.
The mandate of a national bank
is to finance the sustainable development of the
national economy, and its function aims to adjust the
value of a nation's currency to a level best suited for
achieving that purpose within a regime of exchange
control. On the other hand, the mandate of a modern-day
central bank is to safeguard the value of a nation's
currency in a globalized financial market of no or
minimal exchange control, by adjusting the national
economy to sustain that narrow objective, through
domestic fiscal austerity, economic recession and
negative growth if necessary. International trade under
central banking dominated by dollar hegemony becomes a
race toward the bottom with beggar thy neighbor
competition, rather than true comparative advantage.
In response to dollar hegemony, PBoC has adopted
a monetary policy stance in 2004 designed to rein in
excessive money and credit growth, avoid excessive
interest rates volatility and accelerate interest rate
liberalization. Such a policy stance deals with the
symptoms but not the causes of economic trends deemed
undesirable by policymakers. Moreover, these policy
objectives are cross-neutralizing on one another.
The
PBoC expects to keep M1 (currency in circulation plus
the checkable deposits in depository institutions) and
M2 (M2 includes M1 plus retail non-transaction time
deposits) growth rate at around 17% for 2004,
still a destabilizingly high rate when GDP (gross domestic
product) growth is targeted to be less than 7%. The outstanding
yuan broad money, or M2, including money in circulation
and all bank deposits, surged 19.1% year-on-year to
23.36 trillion yuan ($2.8 trillion) by the end of April
2004, albeit the increase was slightly less than that of
March. This M2 level is extraordinarily high in relation
to Chinese GDP of $1.4 trillion, amounting to 200%. The
US M2 was $6.289 trillion in June 2004 against a GDP of
$10.7 trillion, about 60%. And the US money supply is
considered excessive. Much of China's large M2 is caused
by recent massive foreign exchange transmission of hot
money. At the end of July, M2 was up by 20.7% from the
same period last year, higher than the central bank's
planned growth of 17%.
Over the past two
years, China's foreign-exchange reserves have grown rapidly,
not from trade surpluses, but from the inflow of hot
money. This has led to a substantial increase in yuan
"base money" injection as a result of increased foreign
exchange transmission. In line with its overall money
and credit plan, the PBoC has attempted to prevent
excessive growth of base money by withdrawing of yuan
through open market operation. This has the effect of
siphoning money from the domestic sectors to the
export-related sectors where dollar hot money is
concentrated.
Since April 22, the PBoC has
intensified currency withdrawal from circulation through
issuing central bank bills. In 2003, base money
injection as a result of foreign exchange transmission
added up to 1.15 trillion yuan, while open market
operation withdrew 269.4 billion yuan base money,
resulting in a net base money injection of 876.5 billion
yuan. By the end of 2003, the PBoC had made 63 issues of
central bank bills, amounting to 722.68 billion yuan,
leaving an outstanding additional currency amount of
337.68 billion yuan. The money withdrawal came from the
domestic sectors and the injection went mostly to export
and export-related sectors, including speculative real
estate markets. The bulk of the yuan withdrawal went to
foreign reserves holdings. This monetary exercise was
essentially borrowing from the yuan economy to finance
the rise in China's foreign reserves, which lent mostly
to the dollar economy in the form of US Treasuries.
The PBoC also aims to keep new bank lending for
2004 around 2.6 trillion yuan. Banks lent 835.1 billion
yuan in new loans in the first quarter, representing 32%
of the annual target and an increase of 24.7 billion
yuan from a year ago. New loans by commercial banks
between January and July soared to 1.9 trillion yuan,
more than the 1.8 trillion yuan that they lent in all of
2002. But as banks are bypassed in the US by debt
securitization in credit markets, Chinese banks are
being bypassed by the age-old tradition of private loan
syndication, which historically have been the financing
of choice among overseas Chinese, when banks around the
world routinely discriminated against immigrant Chinese
borrowers and forced them to develop their own ethnic
credit market.
Macro measures have
little effect on this growing informal Chinese domestic
credit market, where interest rates can be higher than
sub-prime credit-card rates in the US. The real problem is the absence
of an effective national credit allocation policy.
Central bank interest-rate liberalization works against a
national credit allocation policy and allows the market
to do the allocation. In unregulated credit markets,
credit flows to borrowers willing to pay the highest
interest cost, which usually means the highest-risk
speculative ventures, rather than to where the national
economy needs credit most.
The PBoC claims
that the ultimate objective of this monetary policy stance
is to maintain balanced economic growth at a 7% rate
target for 2004, holding consumer price index (CPI) around
3%. With "macroeconomic adjustment and regulatory
measures", the hangover effect is expected to contribute 2.2%
to CPI, with new inflation factors and price
adjustment policies contributing 1%. The main monetary
policy instruments are open market operation, bank
reserve requirement, interest-rate policy, re-lending and
re-discount, and credit policy.
The PBoC measures growth
by GDP readings, as is common by international standards.
Gross domestic product is a measure of national income.
Dollar hegemony distorts GDP as a reliable index of
growth for non-dollar economies since GDP includes
foreign-reserves holdings when in effect such funds have left the
local currency economy. Taking away annual rises in
foreign-reserves holdings, real Chinese GDP is substantially lower
than the $1.4 trillion figure. Take away also foreign-factor
income in the form of returns on foreign capital, and real
Chinese GDP may be half of what the misleading
statistics show, since 54% of China's exports are
traded by foreign investors. If one should ask to where
has all the money gone given China's annual GDP growth
of 9%, the answer is that most of it went to the dollar
economy.
Moreover, this policy stance
is in essence a neo-liberal supply-side approach. It is
couched in typical policy jargon prevalent among central
bankers, trapped by the flawed logic of the Washington
Consensus and International Monetary Fund (IMF) snake-oil
orthodoxy. The Chinese economy at this stage of its
development does not need a tight monetary policy to
fight overheating in some sectors any more than Chinese
agriculture needs a drought to prevent soil-erosion from
spring flood. What China needs is a new focused credit
policy to shift from dependence on dollar-financed and
-denominated export, and to institute full deployment of
yuan sovereign credit insulated from dollar hegemony to
finance the rapid development of its undeveloped
domestic economy.
It needs to dampen the overheated
export sectors with administrative means and stop
letting an unregulated international financial market
direct national economic policy. China needs to stop
exporting real wealth by reducing export of goods
produced by low wages for useless fiat dollars and
refocus on real growth of its domestic economy. China
needs to free its currency from dollar hegemony and to
stop letting the international credit market dictate
national development. Wealth denominated in dollars has
very limited use in China. It only forces the PBoC to
inject yuan money supply into China's export sector so
that China can finance US national debt with its dollar
trade surplus.
Financial comprador mentality is
apparently dominating the policy establishment in the
PBoC, which mistakes the size of its foreign reserves
for national financial strength and confuses the health
of the banking system under its regulatory supervision
with the economic health of the nation. China's banks
are basket cases only because China chooses to shift
from a national banking regime to a central banking
regime. Now the central bank wants to sacrifice the
national economy to cure sick private commercial banks
under its supervision, whose sickness ironically has
been caused by a central banking regime.
Forex folly Under dollar hegemony, an economy
that holds or needs to hold large foreign-exchange
reserves in the form of dollars is a financially weak
economy. The need for foreign reserves is clear evidence
that the rest of the world has no confidence in that
country's currency and by extension, its domestic
economy. The US, a global financial powerhouse, holds
very little foreign currency. Japan and Germany, as
defeated nations of World War II, have no option other
than to be trapped in an international finance
architecture dominated by dollar hegemony. It is a sign
of serious poverty of insight, creativity and
independent thought at the top that China's monetary
establishment chooses voluntarily to play the same
handicapped game as these two once-vanquished nations.
At the
same time, the PBoC has provided liquidity to support
the privatization of financial institutions through
flexible market operation. This liquidity is not used to
finance national economic expansion, but to finance
initial public offerings (IPOs) of privatized banks.
Banks in a national banking regime are social
institutions, but in a central banking regime, banks are
private institutions. Privatization of social
institutions is a dubious neo-liberal undertaking that
requires close government supervision and regulation to
justify. Central-bank-provided liquidity for the purpose
of facilitating the privatization of state-owned banks
takes on the form of legalized theft from the public. It
provides public subsidy in the form of interest-free
loans to the favored buyers of the privatized banks.
At the end
of August 2003, the IPO of Huaxia Bank led to
substantial liquidity shortage in commercial banks.
Under such a circumstance, the PBoC, on August 26 and
September 2, 2003, twice reduced the issuance scale of
three-month central bank bills and injected liquidity to
commercial banks through seven-day reverse repo
transactions. At the time of the Changjiang Power IPO on
November 11, 2003, the PBC again conducted seven-day
reserve repo transactions. Under the guidance of open
market operation, the seven-day repo rate and typical
inter-bank interest rates remained stable at around
2.15% despite liquidity volatility resulting from IPOs,
which indicated that open market operation reached
expected targets. Free money was handed over by the
central bank to favored private borrowers to buy
privatized state-owned assets.
Given
sufficient liquidity of financial institutions and
falling trend of money market rates during the first
quarter of 2004, the PBoC intensified sterilization
operation, using open market operations to counteract
the effects of exchange market intervention on the
country's monetary base. In this period, the cumulative
amount of central bill issuance reached 435.2 billion
yuan and outstanding amount stood at 615.45 billion
yuan. Base money injection as a result of foreign
exchange purchase amounted to 291.6 billion yuan, and
open market operation withdrew 281 billion yuan,
resulting in a net base money injection of 10.6 billion
yuan and basically offsetting the foreign exchange
position of base money.
With fixed exchange rates, when
excess foreign currency seeks to exchange into the home
currency, as in the case of China in the past two years,
the monetary authority must supply additional home
currencies to keep the exchange rate fixed, even with
controlled convertibility. The monetary authority buys
up the excess foreign currency with local currency and
increases its foreign exchange reserves. This operation
increases the supply of home currency in private
circulation. When a central bank intervenes to keep a
fixed exchange rate, it needs to sterilize its foreign
exchange intervention by taking separate actions to
prevent the home money supply from rising or falling due
to foreign exchange intervention. In the case of
sterilization, the authorities will simultaneously buy
or sell foreign currency and sell or buy
interest-bearing domestic debt or assets to remove the
excess or add depleted home currency, offsetting any
effect on the home money supply.
However,
if the money supply stays unchanged, then according to
the laws of open interest-rate parity, the monetary
authority can keep the exchange rate fixed only by
lowering domestic interest rates. Any excess supply of
foreign currency that existed before will remain. It
disappears only from the domestic money supply, and now
reappears in the form of foreign-exchange reserves. The
home interest rate will have to fall to offset pressure
on the exchange rate to rise. Otherwise, inflow of hot
money will continue.
Thus the recent rise of the
one-year benchmark interest rate by 27 basis points to
5.58%, effective from October 29, 2004 - the first such
hike in nine years - with the rise of one-year deposit
rate to 2.25% from 1.98%, is a counterproductive move in
the context of managing hot-money inflow. The central
bank also moved a step toward the goal of interest-rate
liberalization, scrapping the upper limits on yuan
lending rates. Banks can now charge as much as they want
for yuan loans. The last time the PBoC raised lending
rates was in July 1995, and the rates were last changed
in February 2002, when they were lowered to boost a
sluggish economy.
These measures will only attract
more inflow of hot dollars that had been caused by the
gap between dollar interest rates and yuan interest
rates to begin with. According to the principle of open
interest-rate parity, if a monetary authority
sterilizes, its ability to keep the exchange rate fixed
depends on the market's aversion to exchange risk - an
aversion ironically exacerbated by a fixed exchange rate
not supported by a corresponding interest rate policy.
Thus it is irrational for the PBoC to raise interest
rates to cool the economy while the overheating was
created by an inflow in hot foreign money due to high
yuan interest rates. Those who advise the PBoC to raise
yuan interest rates lack adequate understanding of the
relationship between interest rates and foreign-exchange
rates and the impact of hot foreign money on domestic
money supply in a fixed exchange-rate regime.
A central
bank wanting to hold the exchange rate of its currency
fixed against upward market pressure supplies domestic
currency to the market, creating pressure for the
nominal interest rate of the home currency to fall. This
causes bonds prices to rise. A fall in the nominal
interest rate spurs aggregate demand, which causes GDP
and the price level of the economy to rise. This
expansion of the economy - in particular, the rise in
consumption and investment - may have been a completely
unintended side effect of the central bank's actions.
A
foreign-exchange intervention is said to be unsterilized
if its effects are allowed to pass through to domestic
inflation and domestic GDP, and is said to be sterilized
if its effects are not allowed to pass through. A
central bank sterilizes its foreign-exchange
interventions with open-market operation following
foreign-exchange intervention. The central bank's desire
to fix the domestic currency below market pressure leads
to an expansion of domestic money supply, causing
nominal interest rates to fall, which then spurs
aggregate demand. If the central bank does not want to
affect aggregate demand, then an open-market operation
to maintain the nominal interest rate at its
pre-intervention level is normally required. But there
are alternative regulatory options, such as lifting bank
reserve requirements, if the central bank does not want
to change interest rates, albeit such alternatives are
not without economic cost. The PBoC had elected to
employ such alternatives until it succumbed to raising
yuan interest rates in October.
In order
to rein in the obviously excessive credit growth, the
PBoC had raised the required reserve ratio by 1% to 7%
on September 21, 2003. The central bank raised the
reserve requirement for commercial banks by half a
percentage point to 7.5% effective April 25, 2004, and
has called for banks, enterprises and local governments
to help curb investments and cool down the economy. The
new requirement applies to the country's big four
state-owned banks, 11 joint-stock banks and more than
100 urban and rural commercial banks. However, thousands
of rural and urban credit cooperatives will maintain the
existing 6% reserve requirement.
Bank
reserves are a percentage of total deposits that
commercial banks must maintain for risk management. Only
deposits over the minimum set by the central bank may be
used for lending. The higher reserve will freeze
approximately an additional 110 billion yuan (US$13.3
billion) in commercial banks' liquidity. The
0.5-percentage-point reserve hike is largely to prevent
runaway growth of money and credit and keep the national
economy expanding on a steady, fast and healthy track.
Excessive credit growth could cause inflation, asset
price bubbles, new non-performing loans at commercial
banks and systemic financial risks. Financial
institutions' reserves at the central bank now exceed 2
trillion yuan. The China Banking Regulatory Commission
(CBRC) has ordered banks to stop lending to steel,
aluminum, cement, real estate and automobile industries.
Calling on the reserve Conventional money and banking
theories regard required reserve ratio hiked as a
relatively drastic measure compared with changes in
interest rates. Nevertheless, the PBoC interpreted it as
a mild and preferred move. The reason is that the PBoC
has to withdraw a large amount of excess liquidity
because of fast growth of foreign-exchange reserves. To
do so, if the central bank only issues CB bills without
any other measure, it has to raise the interest rates on
CB bills to a very high level given strong expansion
momentum in the export sector and the commercial banks'
wide interest-rate differentials over the returns on CB
bills. However, a high interest rate would have
significant adverse implications on the whole economy.
Moreover, it would exacerbate the inflow of hot foreign
money. In contrast, the 1.5% rise of required reserve
ratio enabled the central bank to reduce at a lower
economic cost the commercial banks' excess reserve by
about 260 billion yuan, accounting for only 9% of their
holdings of Treasury bills, financial bonds and CB
bills.
Therefore, the new required reserve
ratio hike was considered a comparatively mild policy
measure. The operative word is "comparatively", for the
measure was far from mild. Still, the policy was
announced one month in advance, giving time for
financial institutions to manage their liquidity. The
PBoC also provided timely support to those financial
institutions with short-term liquidity difficulties so
as to maintain the overall stable development of
financial operation and money market interest rates.
Still, with each additional percentage point of reserve
requirement tying down 260 billion yuan in excess
reserves, a 7.5% reserve ratio translates into a
reduction of more than 1 trillion yuan of bank loans,
which may help achieve the new lending target for 2004
to around 2.6 trillion yuan, but it would not provide
much help to the economy, particularly the depressed
sectors. Since the overheating is concentrated mostly in
export and export-related sectors of the economy, there
is no compelling logic to reduce aggregate demand for
the whole economy with a nationwide bank reserve ratio.
But a
larger question about the monetary effectiveness of bank
reserve requirements needs to be addressed. Reserve
requirements, a tool of monetary policy, are computed as
percentages of deposits that banks must hold as vault
cash or on deposit at a central bank. Reserve
requirements represent a cost to the banking system.
Bank reserves are used in the day-to-day implementation
of monetary policy by the central bank.
As of
June, the reserve requirement for US banks was 10% on
transaction deposits (checking and other accounts from
which transfers can be made to third parties), and there
were zero reserves required for time deposits. The US
Monetary Control Act (MCA) of 1980 authorizes the Fed's
Board of Governors to impose a reserve requirement of
from 8% to 14% on transaction deposits and of up to 9%
on non-personal time deposits (those not held by an
individual or sole proprietorship). The Fed may also
impose a reserve requirement of any size on the amount
depository institutions in the US owe, on a net basis,
to their foreign affiliates or to other foreign banks.
Under the MCA, the Fed may not impose reserve
requirements against personal time deposits except in
extraordinary circumstances, after consultation with
Congress, and by the affirmative vote of at least five
of the seven members of the Board of Governors.
In order
to lighten the reserve requirements on small banks, the
MCA provided that the requirement in 1980 would be only
3% for the first $25 million of a bank's transaction
accounts, and that the figure would be adjusted annually
by a factor equal to 80% of the percentage change in
total transaction accounts in the US. An adjustment late
in 2003 put the amount at $45.4 million. Similarly, the
Garn-St Germain Act of 1982 provided for a 0% reserve
requirement for the first $2 million of a bank's
deposits. This level, too, rises each year as deposits
grow, but it is not adjusted for declines in deposits.
For 2004, that level is $6.6 million. The
transactions-account reserve requirement is applied to
deposits over a two-week period: a bank's average
reserves over the period ending every other Wednesday
must equal the required percentage of its average
deposits in the two-week period ending the Monday
sixteen days earlier. Banks receive credit in one
two-week period for small amounts of excess reserves
they hold in the previous period. Similarly, a small
deficiency in one period may be made up with excess
reserves in the following period. Banks that fail to
meet their reserve requirements can be subject to
financial penalties.
Reserve requirements affect the
potential of the banking system to create transaction
deposits. If the reserve requirement is 10%, for
example, a bank that receives a $100 deposit may lend
out $90 of that deposit. If the borrower then writes a
check to someone who deposits the $90, the bank
receiving that deposit can lend out $81. As the process
continues, the banking system can expand the initial
deposit of $100 into a maximum of $1,000 of money. In
contrast, with a 20% reserve requirement, the banking
system would be able to expand the initial $100 deposit
into a maximum of $500. Thus, higher reserve
requirements should result in reduced money creation by
banks and, in turn, in reduced economic activity. In practice, the connection between
reserve requirements and money creation is not nearly as
strong as the exercise above would suggest. Reserve
requirements apply only to transaction accounts, which
are components of M1, a narrowly defined measure of
money. Deposits that are components of M2 and M3 (but
not M1), such as savings accounts and time deposits,
have no reserve requirements and therefore can expand
without regard to reserve levels. Furthermore, the
Federal Reserve operates in a way that permits banks to
acquire the reserves they need to meet their
requirements from the money market so long as they are
willing to pay the prevailing price (the federal funds
rate) for borrowed reserves. Consequently, reserve
requirements currently play a relatively limited role in
money creation in the US.
Reserve requirements, the discount
rate (the interest rate that Federal Reserve Banks
charge depository institutions for short-term loans),
and open market operations (buying and selling of
government securities) are the Fed's three main tools of
monetary policy. There is a continual flow of reserves
among banks, representing the ever-changing supply and
demand for these reserves at individual banks. When the
Fed engages in open market operations, it adds to or
subtracts from the supply of reserves. The effectiveness
of the Fed's actions results from the reasonably
predictable demand for reserves that is created by
reserve requirements.
The Fed changes reserve
requirements for monetary policy purposes only
infrequently. Reserve requirements impose a cost on the
banks equal to the foregone interest on the amount by
which required reserves exceed the reserves that banks
would voluntarily hold in order to conduct their
business, and the Fed has been hesitant to make changes
that would increase that cost. There have been only a
handful of policy-related reserve requirement changes
since the MCA was passed in 1980. In March 1983, the Fed
eliminated the reserve requirement on non-personal time
deposits with maturities of 30 months or more, and in
September 1983, it reduced that minimum maturity to 18
months. Then, in December 1990, the Fed cut the
requirement on non-personal time deposits and on net
Eurocurrency liabilities from 3% to 0%. In April 1992,
it cut the requirement on transaction deposits from 12%
to 10%. In announcing its December 1990 move, the Fed
noted that the cut would reduce banks' costs, "providing
added incentive to lend to creditworthy borrowers".
Similarly, in announcing its April 1992 cut in reserve
requirements, the Fed observed that the reduction would
put banks "in a better position to extend credit".
Current
reserve requirements are low by historical standards.
From 1937 to 1958, the rate on demand deposits was
always at least 20% for banks in New York and Chicago,
which were "central reserve cities" - a term now
obsolete. Before the passage of the MCA in 1980, only
banks that were members of the Federal Reserve System
had to meet the Fed's reserve requirements.
State-chartered banks that were not Federal Reserve
members had to meet their state's reserve requirements,
which typically were lower. As a result, many banks
dropped their Federal Reserve membership and member bank
transaction deposits fell from nearly 85% of total US
transaction deposits in the late 1950s to 65% two
decades later, weakening the Fed's ability to influence
the money supply.
The MCA sought to solve this
problem by authorizing the Fed to set reserve
requirements for all depository institutions, regardless
of Fed membership status. The Fed has long advocated the
payment of interest on the reserves that banks maintain
at Federal Reserve Banks. Such a step would have to be
approved by Congress, which traditionally has been
opposed to this because of the revenue loss that would
result to the US Treasury. Each year the Treasury
receives the Fed's revenue that is in excess of its
expenses. The payment of interest on reserves would be
an additional expense to the Fed.
Capital adequacy Apart from bank reserve requirement
that is designed to insure liquidity, a private bank's
capital - also known as equity - is the margin by which
creditors are covered if the bank's assets were
liquidated. A measure of a bank's financial health is
its capital/asset ratio, which is required to be above a
prescribed minimum international standard set by the
Bank of International Settlement (BIS), whose rules set
requirements on two categories of capital, Tier 1
capital and Total capital. Tier 1 capital is the book
value of its stock plus retained earnings. Tier 2
capital is loan-loss reserves plus subordinated debt.
Total capital is the sum of Tier 1 and Tier 2 capital.
Tier 1 capital must be at least 4% of total
risk-weighted assets. Total capital must be at least 8%
of total risk-weighted assets. When a bank creates a
deposit to fund a loan, its assets and liabilities
increase equally, with no increase in equity. That
causes its capital ratio to drop. Thus the capital
requirement limits the total amount of credit that a
bank may issue. It is important to note that the capital
requirement applies to assets while the bank reserve
requirement applies to liabilities.
The China
Banking Regulatory Commission (CBRC) announced new
regulations on capital adequacy on February 27 in a bid
to enhance risk management of the banking sector in line
with the BIS Basel Accord. After injecting $45 billion
equity into two big state banks, China's foreign
exchange reserves stood at $403.25 billion at the end of
2003. Under the stricter regulations, which took effect
on March 1, capital adequacy ratios of Chinese
commercial banks fell further below requirements. To
give commercial banks more time to replenish their
capital base, the CBRC has set the deadline for meeting
the new requirements at January 1, 2007. Most of China's
commercial banks fail to meet the 8% minimum requirement
for capital adequacy even under the older rules, which
has stood as a major obstacle hindering bank reform
efforts.
Chinese commercial banks are
required to set aside part of their profits as bad loan
provisions, but few of them have been able to meet that
requirement. The vast amount of non-performing loans
means, in some cases, that some banks have to set aside
more money than the net profit they make. Under the new
rules, the capital adequacy ratio - capital divided by
risk-weighted assets - is calculated after a full
deduction of bad loan provisions. Banks are required to
fully set aside reserves only after 2005. The new rules
end some favorable treatment in assigning risk weights
to loans given to key state-owned enterprises and some
types of mortgage loans. The rules allow the CBRC to
give differentiated regulatory treatments to banks with
different capital adequacy levels. The CBRC has the
authority to take over or urge for restructuring of
banks with "seriously low" capital adequacy ratios.
The PBoC
announced on March 25 that the required reserve ratio
for financial institutions with capital adequacy ratio
below a specific level would rise 0.5% to 7.5%, while
the ratio for other financial institutions remained
unchanged. State-owned commercial banks, urban and rural
credit cooperatives were exempt from the differentiated
required reserve ratio policy. On April 11, the PBoC
announced again that the required reserve ratio for all
financial institutions except from urban and rural
credit cooperatives (RCC) would rise 0.5% effective
April 25. The differentiated required reserve ratio
scheme was explained as both a transitional policy in
line with China's current financial system and an
innovation based on the original purpose of required
reserve ratio policy, i.e. to ensure payment and
settlement of commercial banks, and to prevent
over-lending by financial institutions attracted to
profitable loan terms which may undermine their
liquidity and payment capacity. A period of one month is
hardly a reasonable transition period for bank policy
changes.
The required reserve ratio policy
then gradually evolved into a monetary policy instrument
and the deposit insurance regime combined with
supervision on capital adequacy ratio started to replace
it as policy tools to impose prompt corrective actions
on financial institutions based on different risk
profiles. Given the fact that China has yet to establish
a deposit insurance system and quite a number of
financial institutions failed to reach the 8% capital
adequacy ratio, the differentiated required reserve
ratio scheme is conducive to curb excessive credit
expansion of financial institutions with low capital
adequacy ratio and poor asset quality, and to prevent
the one-size-fits-all approach in macro financial
adjustment and regulation. Yet a one-size-fits-all
approach is basic to central banking standardization, an
institutional flaw that central banks seek to correct
with complex exceptions.
At the same time, the PBoC aims to
strengthen credit management by rigorously curbing loans
to over-invested industries, and keeping the proportion
of medium- and long-term loans at reasonable level. The
PBoC will also endeavor to adjust loan structure, urge
financial institutions to implement credit policy,
promote financial ecological development, enhance
re-lending and rediscount management, continue to
improve and prioritize financial service to the rural
economy, and further promote inter-bank market
development. These are positive moves in support of
national development, but hardly profit-driven market
strategies for private banks.
The
priority of China's current interest rate policy is to
enhance institutional reform so as to facilitate
monetary policy transmission mechanism. This is a
questionable priority unless institutional reform
supports national economic development. A legitimate
question centers on the validity of the assumption that
a move toward market fundamentalism enhances national
economic goals. The goal of all financial markets is to
maximize private profit and in an unregulated market,
private profit maximization often runs counter to
national economic interests.
Since
September 2003, the year-on-year consumer price index
(CPI) level has grown rapidly to 3.2% at the end of
December, implying increasing inflation pressure. From
January to March 2004, the CPI rose 3.2%, 2.1%, and 3.1%
respectively and month-to-month rose 1.1%, fell 0.2% and
rose 0.3% respectively. The CPI in the first half of
this year may continue to rise, but current one-year
loan rate is 5.58%, rising 27 basis points from 5.31%
after nine years. If real loan rates should fall
negative at some point in time, the behavior of market
participants will be distorted.
Already,
firms can make profits simply by borrowing to acquire
and hold inventory in certain overheated sectors, thus
aggravating raw material shortage, pushing price level
further up and leading funds to circulate in retailing
rather than be invested in manufacturing. Therefore, the
price level is one indicator the central bank must
closely monitor when considering interest rate policy.
Yet the Chinese economy is still highly disaggregated.
Wide disparities in CPI readings are registered in
different regions and economic sectors. This leads to
the question about the validity of a unified national
interest rate policy. Even in the US, where the economy
is highly aggregated, the Federal Reserve System is
comprised of 12 regional Federal Reserve Banks with 24
branches to monitor local economic conditions.
In
addition, the central bank is forced to take into
account the destabilizing force of speculative foreign
exchange arbitrage. Over the past two years, capital
inflows have led to a substantial rise in China's
foreign-exchange position. The amount of capital inflow
is directly linked to domestic and foreign interest rate
differentials. To deal with the problem, the PBoC
adopted a floating re-lending rate regime. Re-lending
refers to the loans central bank grants to financial
institutions. Floating re-lending rate regime means the
PBoC, according to macroeconomic and financial
situations, can set and announce the extent by which the
re-lending rates move above benchmark rates within the
fluctuation band authorized by the State Council.
Effective
from March 25, the rates on one-year-or-less liquidity
re-lending rose by 0.63 percentage point from existing
benchmark level. In order to support agricultural
development, floating re-lending rate regime for rural
credit cooperatives (RCCs) will be implemented gradually
over a period of three years, and three years later the
rate increments for RCCs will be half of those for other
financial institutions. The PBoC considers the adoption
of a floating re-lending rate regime as another
important step toward interest rate liberalization. It
claims to help not only improve the interest-rate
formation mechanism and the central bank's capability of
guiding market rates, but also upgrade the effectiveness
and transparency of re-lending management. Such claims
stretch monetary logic and policy credibility.
Loan rate resetting Since January 1, the ways of
resetting loan (excluding household mortgages) rates are
being determined by borrowers and lenders through
negotiation. The frequency of resetting rates on medium-
and long-term yuan loans, previously once a year and now
determined by borrowers and lenders, can be monthly,
quarterly, annual, or fixed. This policy move has
corrected the asymmetry between fixed deposit rates and
annually changed loan rates. Consequently, commercial
banks can determine the way of resetting loan rates
according to customer's credit rating, and flexibly
design loan products. Also, shortened resetting
intervals help commercial banks spot borrower solvency
problems earlier. In addition, when the central bank
changes benchmark rates, commercial banks can more
promptly adjust loan rates based on lending agreements,
thus mitigating interest rate risk, facilitating the
transmission of monetary policy to manufacturing and
consumption.
The change of loan rates resetting
policy forced commercial banks to establish offer
system, to factor in credit risk and interest risk when
estimating profits, and to set up internal transfer
pricing mechanism. Yet often commercial banks fall into
liquidity difficulties when the central bank abruptly
and unexpectedly reverses interest rate trends. Since
economic trends generally develop slowly, it would be
reasonable to expect the central bank to make its
interest rate calls with minimum element of surprise and
with ample lead time. Yet central banks tend to play cat
and mouse with the market on its monetary policy moves,
making them major market-destabilizing agents.
With the
control of lending scale and deposit/lending rates, the
commercial banks' asset and liability management (ALM)
only focuses on the ratio of deposit to lending.
Interest rate liberalization, nevertheless, requires
commercial banks to focus on interest rate risk and
capital adequacy ratio. Loan rate floor management calls
for commercial banks to adjust asset structure with risk
pricing. According to a survey in 2002, less than half
of outstanding commercial bank lending is at fixed rate,
while in publicly traded commercial banks, the
percentage of fixed rate loans is only 36. Since the
0.9-1.7-percentage-point floating range has basically
liberalized lending rates, commercial banks now must
learn to price risk. This is because China and Asia
generally do not have a well-developed sovereign credit
market providing long-term sovereign debt instruments as
benchmark for bank loans and mortgages.
Bank loan
pricing then must take into account such complex factors
as short-term fund cost, direct and indirect costs, loan
taxation cost, loan maturity, loan risk and profit
targets. Fund cost rate refers to the cost for
commercial banks to obtain fund in the market with
similar maturity and cash flows as the loan extended to
clients, i.e. the internal transfer price of the loan.
Direct costs, including all costs related to loan
product and client services, can be derived from direct
cost rate using activity-based-cost (ABC) or
average-cost method. Indirect costs, generated from
operations other than loan activities, can be calculated
using the average-cost method. Because the calculation
of direct and indirect costs both use historical data,
the data must be updated regularly so as to ensure its
effectiveness and applicability.
In China,
taxation cost rate is the operating tax rate plus added
cost per loan. Credit risk premium is used to cover
expected loan loss and the expected loan loss rate
equals default rate multiplied by loan loss rate. To
estimate loan loss, commercial banks must set up
internal rating modes. The longer the loan's maturity,
the higher should be the lending rate. The logic behind
is that longer maturity means longer financing period,
consequently higher financing cost and greater
possibility of changing cost. Therefore, the loan rates
should rise accordingly. Profit targets can be estimated
using return on capital and the ratio of capital to
lending.
At present, loan pricing is one
weakness of China's commercial banks because of a
history of interest rate control. In the process of
interest rate liberalization in coming years, commercial
banks need to step up efforts in pricing products,
accumulate experience and develop basic data analysis to
strengthen international competitiveness. But interest
rate liberalization comes with an economic cost. The IMF
has been rightly criticized for prioritizing the
soundness of lending institutions over the health of
borrowing economies by allowing interest payments to
overwhelm the budget of many borrower governments. It is
not a rational policy to destroy a national economy to
save its adventuresome banking system, much less so a
foreign adventuresome banking system.
Deposit
rate ceiling management requires commercial banks to
actively adjust their liability scale and structure, and
adapt themselves to capital adequacy ratio management.
Commercial banking management theories have evolved from
asset management, to liability management, finally to
asset and liability management (ALM). Liability
management for banks originated at the end of the 1960s,
when high inflation and sharp and unexpected interest
rate hike combined with rigorous interest rate control
in many countries and led to disintermediation and fund
shortage in commercial banks, forcing them to adopt
liability management and to attract fund back into
commercial banks through innovation.
Bank
liability management in China emerged from a very
different history. The underdevelopment of capital
markets and securitization of debt in credit markets
have left banks as main intermediaries of credit in Asia
generally and China in particular. In China, funds and
risks are over-concentrated in banks while capital
adequacy ratio of most commercial banks is low. To meet
capital adequacy ratio requirements, commercial banks
must reduce either asset or liability. With a deposit
rate ceiling policy, commercial banks can tailor deposit
price to specific situation. Commercial banks with low
capital adequacy ratio can reduce deposit by lowering
deposit rates so as to mitigate the pressure of
excessively expanding loans to avoid loss due to large
liability. Therefore, deposit rate ceiling policy not
only helps rein in excessive credit growth and mitigate
inflation pressure and non-performing loan risks, but
also guide funds into capital market to promote capital
market development and securitization. Yet savings do
not disappear merely because bank deposit rates are low;
savings only seek other vehicles to achieve higher
returns. With the underdevelopment of credit markets, an
informal credit market emerges outside of control of the
central banks.
Both financial institutions and
their customers need instruments to hedge interest rate
risks in a liberalized interest rate regime.
Option-pricing theory states that financial
institutions, even without derivatives, can use basic
instruments to create transactions with the same nature
as derivatives to hedge risks. Derivative hedging is
cost-effective and convenient. But its advantages to the
hedging parties are derived from transfers of unit risk
to systemic risk. The nature of derivative transaction
requires high leverage, a risk reflected in the meltdown
of major hedge funds such as LTCM. In this regard, China
needs to enhance fundamentally the internal control of
financial institutions before pushing toward derivative
transactions to provide commercial banks and customers
with hedging instruments.
The era of $50 oil will greatly
impact the global economy. Asia will be directly
affected. With the Chinese economy overheated, rising
oil price will exacerbate inflation pressures.
Conventional wisdom suggests that this adds greater
pressure on interest rate rise. China is the second
largest oil consumer in the world after the US. Yet half
the Chinese demand can be met with domestic oil
products. The increased demand for imported oil comes
from the expanding Chinese export sector. High oil
prices cast a shadow over global growth prospects, which
could dampen Chinese export growth and thus reduce
Chinese demand for imported oil. But since a higher
price of oil increases the income of oil producers and
the expenditure of oil consumers for the same amount of
oil, high oil price increases world GDP without
expanding the world economy. High oil prices are
inflationary on a global scale.
Chinese
export growth can transform into market share growth
even as the global economy slows down. As China's global
market share in export expands, the value-adding
performance of its trade will correspondingly be
upgraded even if global economic growth slows. High oil
price has limited direct impact on Chinese domestic
consumption since domestic consumption is supplied
mostly by domestic production. So far, domestic
inflation pressure has mainly come from food and farm
produce prices. But oil prices are global. Chinese
domestic oil will seek export markets if domestic prices
stay below world market levels, unless price control is
instituted. Rising prices in imported oil and oil
products and other basic commodities affect mostly
capital industries and the real estate sector. The
manufacturing sector registered no inflation for lack of
pricing power due to overcapacity, even though energy
cost has increased. Cost-pushed inflation in the export
sector has been largely neutralized by reduced profit
margins and productivity increases from worker reduction
and salary decreases.
Oil and
yuan The high oil price has
refocused the debate on the yuan exchange rate. An
upward revaluation of the yuan may temporarily reduce
the nominal cost of imported oil, but the resultant fall
in the dollar will lead oil producers to further raise
oil prices. The US has adopted a "benign neglect"
posture on the falling dollar for devious reasons. And
the chairman of the Fed actually began to "talk down"
the dollar. The European Central Bank is caught in a
dilemma. Since oil is denominated in dollars, a high
euro will help the eurozone on energy cost and help
contain euro inflation and keep euro interest rates low.
As it is, all central banks are trying to keep
short-term interest rate below neutrality because of
high unemployment everywhere. A falling dollar will also
reduce windfall profits for the Organization of
Petroleum Exporting Countries. The US will keep oil
around $50, which is good for oil-producing states such
as Texas; keep the Europeans quiet about a falling
dollar, increase US exports to keep the labor unions
under control, defuse mounting isolationism in Congress
and make it cheaper to foreigners to invest in dollar
assets, keeping dollar asset prices up. There is no
incentive for Washington to alleviate international
tension if that will bring the dollar up. Thus the
monetary argument for multilateralism is also disarmed.
China
has an unbalanced, overheated economy, with some serious
over-investment in some sectors and regions while other
sectors and regions are caught in protracted stagnation
and credit crunch. The key to the Chinese economy lies
in rebalancing export with domestic development and
shifting investment from overheated regions to depressed
underdeveloped regions. This shift requires policy
planning to rein in unregulated markets and to apply
national banking principles to domestic development.
Doctrinaire central banking in support of capital
markets for maximum return on capital at the expense of
national development must be curbed. Improved
risk-management systems alone will not cure the problem
of excess liquidity pouring into unauthorized steel
mills, aluminum smelters and real-estate projects,
causing an inflationary investment bubble. Planned
credit allocation needs to be strengthened in keeping
with the Five-Year Plan, which has been largely ignored
by blind faith in market fundamentalism. China had
139,400 building projects under construction in the
first seven months of 2004, with total investment rising
38% to 11.2 trillion yuan, most of which were located in
over-saturated markets in overheated regions. No amount
of bank risk management can withstand such massive scale
of credit-market failure.
Give credit
where due Credit allocation
is not related to the level of interest rates in a
planned economy. In the US, credit allocation is handled
with tax deductibility of interest payment in
government-encouraged sectors. Much of the credit
misallocation in China has been created by its state
privatization policy to rely on a market economy for
economic growth. This unleashes massive off-budget
spending financed with loans from newly privatized banks
based on unrealistic revenue projections. Such
privatization activities have contributed to the
concentrated surge in domestic loan demand in saturated
markets. When economic growth slows, these loans will
turn non-performing. The overheating in the Chinese
economy is concentrated along the coastal region, with
the rest of the nation left underdeveloped for lack of
credit. It is also concentrated in proliferation of
copycat projects of earlier entrepreneurial successes.
The
Chinese Ministry of Finance had announced that starting
October 1, 1999, interest payment to bank depositors
would be taxed at an annual rate of 20% nationwide. This
action ended four decades of tax-free interest income.
It defies common sense for Xinqiang to have the same
interest tax rate as Shanghai if the government promotes
a policy to shift investment to the interior west.
China's
total tax revenue is less than 12% of GDP, one of the
lowest in the world. This is the residual legacy of a
socialist economy in which tax revenue is not crucial
for financing public expenditure. The use of sovereign
credit for domestic development is conditioned on the
principle of the State Theory of Money, which asserts
that the value of a fiat currency rests on government
authority to tax. In shifting to a "socialist market
economy", China is under-taxed for the full application
of sovereign credit for domestic development. This fact
limits the ability of the central government to plan for
balanced national development. And the Chinese economy
is still highly disaggregated by location. Unlike the
US, where the states enjoy substantial power to set
local tax policies to compete for growth, Chinese
provinces are allotted very limited autonomous authority
in this regard. Thus the depressed, low-growth regions
constantly find themselves at a disadvantaged
competitive position compared to the coastal, developed
ones.
Higher interest rates across the
whole economy affect not only overheated sectors and
regions, but also underperforming sectors and regions.
China's agriculture and service industries have received
less investment compared with natural resource sectors
closely related to the export sector and the real estate
sector in coastal cities. While fixed-asset investments
grew 40%, year-on-year during the year's first quarter,
investments in the nation's agriculture sector rose a
scanty 0.4%.
China's service sector has not
shown any sign of overheating. In fact, education and
health services have experienced declining investment
for more than two decades. Since private investments are
expected by policy to gradually replace government
spending as the economy's main driving force, high
interest rates will cause credit crunches on
fund-strapped sectors while having little influence on
already-overheated sectors. China's policymakers have
been unduly and unwisely influenced by Hong Kong
capitalists whose experience has been limited to real
estate and light manufacturing and have not the
slightest clue on national economic development policy.
By the
end of June, bank loans to the real-estate sector
reached 2.1 trillion yuan, up 36.1% year-on-year. New
investments in land developments increased 28.7%. A
recent field survey by the National Bureau of Statistics
indicated the average property price in 35 of China's
cities increased 10.4% in the year's second quarter
compared with a year ago. In Shanghai, the growth figure
reached an astonishing 20%. In industries supporting
real estate construction such as steel, cement and
building supplies, fixed investment is as high as 172%
(iron and steel). Official government estimates say that
when all steel projects currently under construction
come to full production, they will turn out more steel
in 2005 than the country will be able to use until 2010.
Despite the central government
tightening regulations in the steel, cement and aluminum
sectors, the real estate sector drove steel prices up
2.1% in July from June, and 18% from a year ago. The
price of cement rose 4.7% from June, and 11.6%
year-on-year. The PBoC noted in its 2004 third-quarterly
report on monetary policy that its credit-tightening
measures have prevented new investments in the
real-estate sector, but failed to influence the demand
side. As investments and new projects in land
development continue to decline, demand will
consequently exceed supply. This will push property
prices up. But the demand side in the real estate sector
can be managed in ways besides interest rate hikes, such
as increasing down payment ratio for residential
mortgages to effectively bring down property prices.
But the
real factor behind price inflation in real estate is not
construction cost, but rising land cost, a factor over
which the central bank commands no direct control.
Investments in real estate grew by more than 40% in the
first quarter year-on-year. This is the fastest growth
in China's modern history - almost three times the
25-year average of 15%. What this means is that
investors are pouring money into real estate, which is
jacking up prices and creating an artificial bubble just
waiting to pop. Figures from the end of 2003 estimate
that real-estate vacancies stand at 26%, quadruple the
US figure, eight times Hong Kong's and two and a half
times the international norm. The inventory cannot
possibly be absorbed by domestic consumers whose income
cannot support such speculative prices. These prices are
sustained by speculative momentum.
Yet the
recent interest rate hikes in the US are unlikely to
cause an outflow of speculative funds, or hot money,
from China. Martin Feldstein, president of the National
Bureau of Economic Research and Harvard professor of
economics, has calculated that a 0.25% or even a 1%
increase in dollar interest rate will not make hot money
leave China. This is because China's rigid currency
regime and tight control over capital accounts means
speculative funds will, over the short term, have
trouble finding a way to benefit from the abrupt rate
rises in the US. A short-term rate change would not
affect foreign direct investments (FDI) going into China
as FDI is generally for the long term. On the other
hand, a widely expected US long-term policy of a
measured pace of interest rate hikes will force interest
rates in other currencies to rise.
China's
GDP still grew 9.8% in the first quarter of 2004. Fixed
asset investment reached 879.9 billion yuan, up 43%
year-on-year. The April consumer price index (CPI) also
jumped to 3.8%, compared with 2.8% for the first
quarter. Money supply in the first quarter grew 17% and
new loans reached 2.6 trillion yuan, the second highest
in history. Yet amid these bullish growth data,
unemployment keeps rising. Also in April, construction
of a major steel smelting facility in Jiangsu province
was brought to a screeching halt for alleged illegal
land expropriation and improper borrowing. The move was
widely viewed as part of the effort to halt undesirable
construction in an overheated sector. The State
Development and Reform Commission also conducted a
nationwide price inspection. Local governments were
instructed to halt utility price hikes if inflation in
their areas exceeded national norms.
Financial
institutions lent 1.88 trillion yuan in the first seven
months of 2004, already topping the total for loans in
2002. Interest rates have soared after the release
of these data. The rate on benchmark seven-day
repurchase agreements jumped to above 2.8%, even higher
than the 2.66% coupon on a seven-year sovereign bond
issue earlier in 2004. The problem is that these loans
have been made in the wrong sectors and to the wrong
borrowers.
PBoC has already reversed a
contractive stance it maintained for the first eight
months of 2004 in open market operations, releasing 35
billion yuan of currency in repurchase agreements in
September. The CPI is expected to rise less than 1%. The
auto and real estate sectors, where prices have been
growing the fastest, are currently not factored in
China's CPI. Both sectors appear to be heading for
abrupt slowdowns due to dwindling purchasing power. And
the ex-factory prices for consumer goods, which largely
dictate CPI trends, have been on the decline in 2004.
The CPI, after months of decline, started to rise in
October 2003, hitting 1% in April, but subsided
afterwards. It registered 0.5% rise in August 2004.
Little noticed is that fact the CPI declines often comes
from declining corporate profits.
The
growing investments are partly the result of years of
low investment, fueled by heavy initial investments in
such sectors as automobiles, and may be offset by the
sluggishness in spending. Since August, China's
macroeconomic policy makers have faced a dilemma: either
fail in cooling down the economy or risk causing
economic depression. The official jobless rate is 4.3%
that does not reflect the real situation since it does
not include laid-off workers from state-owned industries
or migrant workers. Even though Chinese workers earn on
average $0.61 an hour, China is losing manufacturing
jobs because of technological advances as employers try
to boost productivity by laying off redundant workers,
given that wages cannot fall below zero. Unskilled
workers can become cost-ineffective against the cost of
automation. Evidence is mounting that job shrinkage can
also occur on low wage levels in a booming economy.
Fixed-asset investment in China
rose 26.3% year-on-year in August 2004, down from 31.1%
in July and far below the 47.8% in the first quarter.
Other key data shows a similar trend. Industrial output
rose 15.9% year-on-year, slightly above a 15.5% rise the
month before but well below the 19.4% first-quarter
growth rate. M2 money growth hit a 3 1/2-year low in
September, growing 13.6%. Household savings deposits
grew 14.9% in the month, considerably down from a
January peak of 20.5%. The Asian Development Bank
forecasts a 13% increase in domestic consumption in 2005
as urban and rural incomes keep rising. Signs that
inflation has peaked, growing 5.3% in August - unchanged
from July - were also welcomed by economists. It was the
first time since February that price rises have not
accelerated. Thus while growth is still at a high rate,
the trend has slowed.
Still
hot Concern is now shifting
from fear of a hard landing to concern that growth will
soon accelerate again as the restrictive measures
gradually lose their initial impact. The corporate
sector can work its way around administrative measures
as they draw from their past experience at evading them.
Continued foreign direct investment, rising inflation
and anecdotal information on distribution bottlenecks
suggest that the economy is not cooling down, at least
in the intended sectors. The last thing the Chinese
economy needs now is a slow down in consumer spending
while capital spending continues.
China's
new rural cooperative medical system has benefited more
than 95 million people since it was implemented last
year. Still, that amounts only to less than 1% of
China's rural population. The new system is mainly used
to help farmers who are impoverished by illness and to
reimburse costly treatment and hospitalization expenses.
The funds come from the central government budget, local
government subsidies and farmers' tax payments. By the
end of September, the funds amounted to three billion
yuan, which translates into $3.50 per capita benefit
recipient. The new system is expected to cover all the
country's rural areas by 2010.
With
threatening over-investments, the PBoC warned that it
"could inflame inflation or asset price bubble,
resulting in new non-performing loans and financial
risks", those financial risks being mass bankruptcies as
the result of market oversupply. Much of this excessive
investment is going into blind investment and duplicate
construction, which pose the same risks. Blind
investment finds banks and independent investors
throwing money at some projects or industries without
any risk assessment, or just following the herd instinct
into a booming, but potentially disastrous, market.
Duplicate construction means jumping on some bandwagon
and over-investing in industries already saturated. For
example, the Zhujiang area in Guangdong has eight
airports in a region the size of Massachusetts and
Connecticut. In addition, local governments fall all
over each other to establish special economic zones, but
43% of the land in such zones remains unused, with no
revenue to service the loans spent to build the enabling
infrastructure.
Curbing bank lending and reining in
bad and redundant investments do not address the
structural causes that have led to these problems. In
1993, similar measures led to a severe recession,
deflation and insolvent banks. Yet market forces have
become stronger in the Chinese economy now than in 1993;
and the rate and scale of investment are much greater
today because of hot money inflow. For example, profits
on investments in the steel industry increased by more
than 100% year-on-year in the first two months of 2004.
By
calculating China's trade revenue against its total
foreign reserves, the amount of hot money flowing into
the country in the first quarter this year may amount to
as much as $30.9 billion, or an increase of 25.6% over
last year, when China's foreign reserves increased by
57%. The central bank needs to sterilize foreign
exchange reserves by selling treasury bonds and to sell
more treasury bonds, it will have to raise interest
rates. This only encourages more hot money as
speculators change their dollars to yuan in anticipation
of a revaluation, collecting higher interest rates until
they can sell back their yuan at a profit. Meanwhile,
China's economy continues to overheat with
over-investment in saturated export sectors, while
inflation ravages other under-invested domestic sectors.
Administratively, the government
has done all it can do within the limits of a market
economy and the economy is still overheating. The loan
curb, the projects halts, the rise in bank reserve
requirement and the interest rate rise have not reduced
overheating in the export sectors, but have created
mounting stress in the domestic sectors. It has been
suggested that a 10-15% revaluation of the yuan would
take speculative pressure off the currency immediately,
and foreign money coming into the country to invest in
overheated industries would slow overnight because
speculators would get fewer yuan for their dollar. At
the same time, such a revaluation would restore
flexibility in managing both fiscal and monetary policy,
enabling policymakers to raise interest rates without
consequences on hot money flow. But high interest rate
will cause an immediate burst of the ongoing hot money
bubble, making the cure worse than the disease.
Some have
suggested that the yuan should be removed from its peg
to the dollar and repegged to a currency basket weighted
on the currencies of China's major trading partners.
This would supposedly maintain the equilibrium value of
the yuan in a dynamic global economy. Once the yuan is
re-pegged, and a new reference basket implemented, any
additional moves, such as widening the trading band,
could be phased in during a transition period of some
years. This would supposedly provide a safe and
effective path to a more flexible exchange rate regime.
But dollar hegemony renders such scheme inoperative. The
exchange value of the yuan is only the symptom and not
the cause of the problem. The problem is that under
dollar hegemony, trade surplus ships wealth to the
dollar economy in the form of added dollar reserves and
trade deficits ship wealth to the dollar economy in the
form of dollar debts. Either way, exporting for dollar
is a losing game for the non-dollar exporting economies.
To
guard against possible risks, Chinese regulators have
launched a probe into foreign exchange acceptance and
settlement operations by commercial banks. The State
Administration of Foreign Exchange (SAFE) said it would
clamp down on illegal cross-border capital flows. An
effective mechanism to more closely monitor the flow of
speculative capital in and out of the country is
urgently needed. For more than 18 months, speculators
both inside and outside China have been betting that the
yuan will appreciate sharply against the US dollar.
But a
significant appreciation now appears less likely. The
constellation of forces that made yuan appreciation
appears unavoidable have now shifted their alignment.
China's current account is in deficit so far this year
and rising, suggesting that from a trade competitiveness
perspective, the yuan is not undervalued on a global
basis. The yuan is not even undervalued to the dollar
since much of the US current account deficit is a
structural component of dollar hegemony, not just an
overvalued currency. In addition, much of what China
wants to buy from the US, particularly high-tech
products, is banned from sale by US policy. Yet a rise
in yuan interest rate was also considered unlikely until
it surprisingly became reality.
The
changing dynamics surrounding inflow of hot money is a
big part of total capital inflow. China's capital
inflows are different from those suffered by South-East
Asian stock markets in the run-up to the financial
crisis of 1997. The speculative funds entering China
have not been destined for domestic stock markets but
rather for the construction and real estate sectors.
Since April, China has issued a series of administrative
orders to cool down construction and property
investments. Some projects have been stopped and others
have found bank financing drying up. The cumulative
effect has been that hot money is finding it
increasingly difficult to find profitable projects.
Hot money
inflows have averaged between $10 billion to $13 billion
a month this year. This, in turn, could mean that
China's foreign currency reserves may start to expand
less quickly month after month. This trend may convince
speculators that pressures on the yuan to revalue are
dissipating. A slowdown in the growth of China's foreign
reserves means that China will be buying less US debts,
creating problem for the US debt bubble and causing
dollar interest rates to rise, thus reducing dollar hot
money from leaving the US.
A sustained drop in foreign central
bank purchases of US debts could add to pressures on the
US Federal Reserve to raise interest rates at a faster
pace. That could support the US dollar's value against
other currencies, thereby bringing the yuan up with it.
But high dollar interest rate can abort the anemic
recovery of the US economy. The alternative facing the
Fed is that it will have no option except to inject more
liquidity into the dollar money supply, by keeping
dollar interest rates below neutral, accepting inflation
as growth. Some of the excess dollar liquidity will find
its way into China as hot money.
Central
bank officials have repeatedly said that China will
continue to lift foreign exchange control to balance
trade and gradually make the yuan a freely convertible
currency. The floating of yuan exchange rate was an
objective set at the Third Plenary Session of the
Fourteenth Central Committee of the Communist Party of
China in 1993, more than a decade ago. But the process
is expected to take a relatively long time. China has
already taken a series of measures to make exchange
under current account easier and to liberalize
restrictions on capital account transactions. However,
trade liberalization, removal of excessive restrictions
on capital account transactions and reform of
state-owned commercial banks need to be accomplished
before adequate flexibility can be introduced in the
exchange rate regime. The difficulties and destabilizing
effects of these moves tend to justify even more
gradualism. The last thing China needs is to repeat
Russia's disastrous shock-treatment market
liberalization, from which the former superpower never
recovered.
Nothing to
gain As foreign-funded
financial institutions will be permitted under the terms
of the World Trade Organization (WTO) to conduct yuan
business and substantially broaden their market access
in China by 2006, Chinese state-owned commercial banks
need time to strengthen their competitiveness and
risk-prevention mechanism to viably response to a new
exchange rate regime. The prospect of Chinese commercial
banks being ready for international competition within
two years is almost zero. On the other hand, the
prospect of a global financial crisis caused by dollar
hegemony before 2006 is very high. Those within the
Chinese policy establishment who opposed China's entry
into WTO may have their warnings vindicated. With the
global financial system on the verge of collapse,
isolationism is not an extremist position.
If an
adjustment of the yuan exchange rate makes China's
staple agricultural products uncompetitive with imports,
farmers, especially those in the coastal regions, will
be forced to migrate to cities in a much higher rate,
making non-farm employment demand more acute in cities.
A one-percentage-point fall in agricultural employment
translates to a need of 4 million additional non-farm
jobs. The head of the PBoC has said that given the size
and development stage of China economy, the prevailing
exchange rate regime has been working quite well.
Between 1994 and 1997, the exchange rate of the yuan
against the dollar appreciated from 8.7 to 8.3,
reflecting a managed float regime. At the end of 1997,
at the request of neighboring economies and
international institutions, China substantially narrowed
the floating band of the yuan exchange rate to help
reduce the shock of the Asian financial crisis and
dispel the fear of yuan devaluation. Yet, the central
bank's view is that with the role of the market becoming
increasingly important in the Chinese economy, the
exchange rate of the yuan will increasingly be
determined by market forces.
Although
it was not expected that China would respond
automatically to the recent dollar interest rate hikes,
the PBoC did raise interest rate amid concerns about
rising prices. On September 15, 2003, the Chinese
government issued 2.4 billion yuan of sovereign debt.
China has adopted aggressive financial policies over the
past five years to alleviate deflationary and
unemployment pressures. This has led to a sizable fiscal
deficit that must be made up for by issuing sovereign
debt. Last year, China issued a total of 592.9 billion
yuan of sovereign debt. According to official Chinese
estimates, this year will see the issue of 637.6 billion
yuan of sovereign debt. Increasing market interest rates
will lead to a fall in price of sovereign debt, which
will be disadvantageous to the issue of sovereign debt
to make up for huge budget deficits. This will make
aggressively tight monetary policies difficult.
China
wishes to maintain a fixed exchange rate in order to
maintain export competitiveness and avoid deflation, but
is doing so by creating a sharp increase in the issue of
money, which may lead to an overheated bubble economy,
increasing the amount of non-performing loans and
systemic financial risk. China therefore wants to
tighten money supply by slowing the rate at which money
is issued and suppressing inflation. However, this may
in turn lead to higher interest rates and increase the
cost of monetary policy implementation, while at the
same time possibly increasing the rate at which
speculative hot money enters the country, thereby
increasing the pressure on the yuan to appreciate.
Higher interest rates will lead to falling consumption
and investment across the entire economy, which will
further aggravate China's still very serious
deflationary problem in key domestic sectors. The
government must therefore actively increase fiscal
expenditure. Such is the difficult dilemma currently
faced by Chinese policymakers.
China has
posted price increases for some industrial goods while
others have been leveling off. Declining steel prices as
a result of oversupply are especially a concern.
Overall, prices of industrial goods leaving the factory,
measured by the producer price index (PPI), edged up
0.7% in April 2004 over March and rose 9.3% over the
same month a year earlier. Prices for most basic
commodities such as food, minerals and fuel continued to
rise, while those for consumer goods like television,
washing machine and refrigerator fell. Propped up by
food and raw material price increases, China's consumer
price index rose a modest 2.8% year-on-year from January
to March.
The Chinese government has set a 3%
CPI increase target for 2004 and the central bank
predicted that the index would continue to climb after
April because of the "spill-over" factor and a lower
comparative base from the same 2003 period, when the
Chinese economy was hit by the SARS outbreak, but the
CPI is expected to fall starting from the third quarter.
Nationwide investment in fixed assets, including capital
projects and factory equipment, soared an annualized 43%
in the first quarter, which the central bank blamed
partly on some departments and local governments
neglecting central government calls and keeping
investment robust to score political points. Banks
loaned 835.1 billion yuan in the first quarter,
representing 32% of the annual target and an increase of
24.7 billion yuan from a year ago. The outstanding broad
money, or M2, including money in circulation and all
deposits, surged 19.1% year-on-year to 23.36 trillion
yuan by the end of April. The increase was almost equal
to that of March.
By tightening the monetary policy,
the central bank said its annual targets - letting both
M2 and M1 grow 17% and commercial banks' lending add 2.6
trillion yuan - could be reached. It said the impact of
its policy initiatives such as higher bank reserve
requirement and open market operations, including issue
of central bank bills and treasury bonds trade - would
be felt later. To brake the economy is not the task
confined to the central bank. The State Development and
Reform Commission recently issued a regulation on
controlling rush investments and clearing away copycat
projects; the ministry of land and resources recovered
more than half of China's 6,015 development zones last
year and has stopped approving new such zones. The
international pressure to revalue the yuan is becoming
more an issue of political concern than of economic
significance.
China's agriculture and service
industries have received less investment compared with
sectors related to natural resources and the industries
closely associated with the real estate sector. While
fixed-asset investments grew 40% year-on-year during the
first quarter, investments in agriculture rose only
0.4%. China's service sector has not shown any sign of
overheating. By the end of June, bank loans to the real
estate sector had reached 2.1 trillion yuan, up 36.1%
year-on-year. New investments in land development
increased 28.7%.
A recent field survey by the
National Bureau of Statistics indicated the average
property price in 35 of China's cities increased 10.4%
in the second quarter compared with a year ago. In
Shanghai, the growth figure reached an astonishing 20%.
In July, steel prices rose 2.1% from June, up 18% from a
year ago. Price of cement rose 4.7% from June, and 11.6%
year-on-year. With inflation on the rise, China is
quickly slipping into negative interest rates. A
negative interest rate over a long period would
inevitably deter people from putting their money into
banks. In the second quarter, only 32.2% of those
surveyed have recently chosen to put more savings in
banks, 2.5 and 1.1 percentage points lower than the
figures in the first quarter this year and the same
period last year.
Many people chose to invest in
financial assets other than bank deposits. Investment
funds served as a main channel for diversified household
savings. In the first half of this year, net value of
investment funds increased 132.4 billion yuan, 126.8
billion yuan more than the same period last year. A
rebound in the stock market, especially in the first
four months of this year, has amplified the diversion of
funds from personal bank accounts. As of the end of
July, 71.57 million folks had investment accounts in
China's two stock exchanges, in Shanghai and Shenzhen,
1.86 million more than the same period last year. In the
first half of this year, domestic stock investment
amounted to 35.6 billion yuan, 11.4 billion yuan more
than a year ago.
A higher interest rate on treasury
bonds compared to bank deposits also lured investors. In
the first six months of the year, the ministry of
finance issued five certificate treasury bonds with a
total household investment of 122.7 billion yuan, 114.3
billion yuan more than the same period last year.
Investment in insurance also diverted household savings,
with investment volume in life insurance hitting 178.8
billion yuan within the first six months, 11 billion
yuan more than the figure in the first half 2003.
Altogether, household investment in stocks, funds,
treasury and enterprise bonds, and insurance totaled 482
billion yuan in the first half, 262.6 billion yuan more,
or 1.2 times the figure, compared to the same period
last year.
Increased consumption also
contributed to the drop in household savings. Sputtering
increases of demand has been a prominent problem in the
Chinese economy in recent years. This year, total retail
sales increased 2.95 trillion yuan in the first seven
months, a year-on-year increase of 12.8%. Deducting
price factors, the increase was 4.5 percentage points
higher than that of the same period of 2003. There is
generally an inverse relationship between consumer
spending and household savings.
For a
given supply of money, an increase in the production of
goods will increase the exchange value of a currency
since each unit will buy more goods. Likewise,
increasing the supply of money relative to a fixed
output of goods will lead to a decline in the purchasing
power of money with each currency unit buying fewer
goods. Given the relatively high rate of growth in
China's money supply, there could be considerable
pressures for the yuan to depreciate. This is because a
rate of growth of the money supply that exceeds the
growth rate of economic activity tends to cause the rate
of exchange to fall. Even if exchange rates are fixed
but capital can move freely, capital flight from the
country tends to put pressures to end loose monetary
policies.
When exchange rates are determined
by supply and demand, imbalances can continue for a long
time only if most central banks coordinate their policy
stances. Once they stop following similar monetary
policies, the exchange value of a currency can drop
sharply. In the worst case, the collapse of the exchange
rate can trigger a severe shock to the real side of the
domestic economy. What is happening with respect to
international valuations of the dollar at the moment is
that US central bankers are pumping dollars into the
dollar economy to finance US trade deficits. That forces
US trading partners to pump local currencies in their
economies through foreign reserves transmission. But the
additional dollars is recycled into dollar debts and
stay in the dollar economy. Thus the dollar economy
grows faster than the US economy. So the dollar will
continue to weaken as long as the rate of increase in
new dollars into the dollar economy is greater than the
growth of the US economy. Dollar hegemony prevents
non-dollar central banks from pumping more local
currencies into the economy. Under such conditions,
equilibrium between the dollar economy and the US
economy can only be maintained with the continued fall
of the exchanged value of the dollar.
What China
needs to do is to raise wages, not interest rates, to
increase consumer spending. It is of course plausible
that at some point spending could outgrow the economy's
capacity to produce, causing prices to accelerate to
unacceptable levels. Economists have labeled the
unemployment rate below which this inflationary spiral
would theoretically ignite as the NAIRU, or the
non-accelerating-inflation rate of unemployment. In the
early 1990s, the conventional wisdom among economists,
including most at the Federal Reserve, was that the
unemployment rate could not go below 6% without
triggering an accelerating rate of inflation. The few
economists who pointed out that there was little
empirical evidence to support this theory and that the
economy could achieve non-inflationary unemployment
rates of 4% or even lower were derided by the profession
and ignored by the business media.
The US
unemployment rate has now been below 6% since September
1994, below 5% since June 1997, and below 4.5% since
April 1998. Core inflation has not only not accelerated,
it remains dormant. The NAIRU is revealed as useless as
a guide to economic policy. Every episode of
accelerating inflation in the US since 1960 was led by
prices, not by wages. The current effort to slow down
the Chinese economy, therefore, appears to be targeted
at weakening the bargaining position of labor against
capital. Throughout the economic expansion of last
decade, wages have fallen behind corporate profits in
every economy of the world, including China and the US.
In the US, economist Jared Bernstein has calculated that
even if labor costs were to accelerate to rising 1%
faster than productivity, it would take four years
before wages and profits went back to their respective
shares in the decade of the 1980s.
In moving
toward a socialist market economy, China can benefit
from lessons learned in the US New Deal. The National
Industrial Recovery Act aimed to stabilize industrial
prices, raise wages and promote collective bargaining,
while the Agriculture Adjustment Act aimed to raise farm
prices. These measures were combined with measures for
reforming banking and financial practices and increasing
the supply of money and credit. The New Deal also
appropriated large sums for direct relief for the poor
and the unemployed and for a massive public works
program. Unfortunately, both acts were struck down by a
conservative Supreme Court as unconstitutional, which
fortunately is not a problem for China. But to do that,
China must first insulate its currency from dollar
hegemony and relieve its economic growth from excessive
dependence on export for dollars.
Henry C K
Liu is chairman of the New York-based Liu Investment
Group
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