Page 1 of 2 China's excess liquidity trap
By Pieter Bottelier
China, although its average per capita income is still very low (about US$2,500
in 2007), has become a particularly well-funded country. Household deposits in
the banking system are very high and increasingly liquid; large enterprises are
on average very profitable and cash-rich; the government ran a budget surplus
in 2007; the country is a net exporter of capital and has more foreign exchange
reserves than it knows what do with.
While this situation may sound positive, the associated imbalances in China's
economy are large and increasingly worrisome for the country's leaders. The way
they deal with these challenges will have significant national and
international implications.
Japan's inability to stimulate growth through a reduction in the
central bank's discount rate during the1990s (because the rate had already been
reduced to zero or close to zero), was described by economists as a "liquidity
trap". There was no easy way out for Japan. China's problem today is in some
ways the opposite. One might refer to it an excess liquidity trap. It has three
dimensions, all of which present serious policy dilemmas.
China has to be concerned that excess domestic liquidity will cause economic
overheating, but it is afraid to raise interest rates and tighten monetary
policy more aggressively for fear that it would slow employment growth,
generate additional non-performing loans in the banking system and attract
additional liquidity from abroad.
China cannot continue to sterilize large amounts of excess liquidity in the
banking system indefinitely without risking a qualitative deterioration of the
balance sheet of the central bank, the People's Bank of China (PBoC), a decline
in the profitability of banks (if reserve requirements are raised too high) or
other monetary problems.
It is difficult to protect the value of China's huge foreign exchange reserves
against US dollar decline precisely because the reserves are so huge and
because the dollar's share in those reserves is so large.
The inflation challenge
The increase in China's consumer price index (CPI) for the first five months of
2008 reached a worrying 8% year on year, the highest in more than a decade.
This is the first serious CPI inflation since the inflation cycle of 1992-1995,
but the factors underlying it are very different.
For most of the period between 1998 and early 2007, China's CPI was very low or
negative. Unlike the inflation of the early 1990s, which was driven by an
overheated economy (rapid domestic demand growth fueled by excessive credit
expansion), the current inflation cycle was ignited by incidental domestic
supply-side factors in the food sector (mainly pigs and poultry), reinforced by
sharp global price increases for imported oil, coal, soybeans, other grains and
metals. The combined effect was to drive up the price of many food items
(especially pork, poultry, eggs, vegetable oil and dairy products).
CPI inflation received an extra jolt in the early months of 2008 as a result of
unusually severe winter storms that disrupted transportation and power supply
in the country's south. The non-food CPI has remained surprisingly modest and
stable , but the producer price index (PPI) - a contributor to CPI inflation in
the longer term - has risen sharply in recent months, to 8.2% in May.
The increase in GDP growth from 10.1% in 2004 to 11.9% in 2007 was almost
entirely due to increases in net external demand (trade surplus), not domestic
demand. Monetary expansion in 2007 was moderate; it was not a primary cause of
either CPI or PPI inflation.
Although China's rising import demand for soybeans, oil, coal, metals and other
commodities has undoubtedly contributed to the global commodity price increases
of recent years, from a policy perspective such price increases have to be seen
as exogenous. Because of the size of its economy and high growth, China's
rapidly growing imports of many commodities has a major impact on international
prices. However, China cannot be expected to slow domestic demand growth to
reduce international commodity prices, unless such action is indicated by
domestic policy requirements.
Aggregate bank deposits in China - constituting the bulk of broad money supply
(M2) - have become very large and are still growing. The total reached almost
40 trillion yuan (US$5.6 trillion, over 160% of GDP) at the end of 2007. The
total was composed of about 26 trillion yuan ($3.6 trillion) in household
deposits and about 14 trillion yuan ($1.9 trillion) in enterprise deposits. In
view of the large absolute size of bank deposits, the implications for
international capital markets of a relaxation of controls on private capital
outflows from China are potentially significant. However, it is unlikely that
there will be sudden large outflow of bank deposits from China soon, as will be
explained later.
Since 1999, the composition of household deposits has been slowly shifting from
saving (term) deposits to demand deposits. This shift probably reflects a
growing need of households for liquid assets to finance the purchase of
consumer durables (such as cars), shares and down payments for real estate. It
is not clear why this shift accelerated in 2004, but a plausible explanation
lies in the fact that CPI inflation began to exceed the one-year deposit rate
that year.
It is not clear either why the share of saving deposits slightly increased in
the first quarter of 2008. Enhanced liquidity of M2 (a measure of money supply)
does not automatically contribute to inflation, but it increases the risk that
inflation will become more serious and endemic should inflation expectations
become part of market psychology.
When inflation is driven by exogenous factors, beyond the government's control,
as has been the case since early 2007, a further tightening of monetary policy
may have perverse effects, as it would slow growth without necessarily reducing
inflation. Yet, as the government knows from past experience, social tolerance
for inflation in China is low, regardless of its source.
The government is obviously concerned that a prolonged period of relatively
high CPI inflation may generate inflation expectations, which could trigger new
inflation dynamics that are even harder to control. In this context, the
increasing liquidity of China's broad money supply (M2), as already noted, is
worrisome. It does not necessarily trigger inflation, but it facilitates
inflation should expectations and systemic cost-push factors take over as a
driving factor. To control M2 liquidity - as a general rule - China should
ensure that deposit rates are positive in real terms (with respect to CPI
inflation). In the longer term, it should also try to reduce the M2/GDP ratio
through domestic capital market development and a gradual liberalization of
capital controls.
The sterilization challenge
The central bank's main target for monetary policy is the margin of loanable
funds in the banking system. This margin may become larger than desired for
various reasons, but the most important factor in recent years has been the
large net capital inflow from abroad as is reflected in the steep increase in
foreign exchange (from $291 billion at the end of 2002 to $1.76 trillion at the
end of April 2008).
During the first four months of 2008, China's reserves increased by an average
of $80 billion per month, which would add about $1 trillion to China's reserves
this year if the trend continues. The accumulation of foreign exchange reserves
is in large measure due to China's intervention in foreign exchange markets to
keep the yuan/US$ exchange rate fixed (until the yuan was de-linked from the US
dollar on 21 July 2005) or to prevent it from appreciating faster than the
government feels comfortable with (after 21 July 2005).
Thus far, China's central bank, the PBoC, has been surprisingly successful in
sterilizing excess liquidity in the banking system that resulted from the sharp
increases in net foreign exchange inflows since 2002. This virtually eliminated
inflationary pressures that would otherwise have resulted from excessive credit
expansion and thus prevented the real exchange rate from appreciating.
As mentioned, the CPI inflation that started in 2007 was driven by domestic
supply-side disruptions in the food sector and
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