The Poor State of Chinese Monetary Policy
Throughout most of the past decade when the Chinese economy was growing rapidly thanks in large part to a significantly undervalued exchange rate and a rapid credit expansion, rather than act the adult and take away the punch bowl the PBOC instead pushed additional expansionary policies. Though they prudently raised reserve requirements, the PBOC was the large expander of the money supply excluding countries with major inflation and they kept interest rates too low for too long. The PBOC never made any serious attempt to exert its influence and tools of monetary policy to reduce excessively exuberant economic policies (doing my best central banker imitation there).
However, now the situation is reversed in a slowing economy and the PBOC is running an excessively contractionary monetary policy. There are a number of ways that is this clear and reveals the policy mistakes of the PBOC. First, real interest rates in for even the largest, most credit worthy firms are approximately 10%. Producer deflation in China has been pushing about three years, currently stands at 4%, and has been trending downwards. With even the most credit worthy firms paying at least 5-6% for debt, this implies an approximate real interest rate of 10%. Especially in an economy with significant downward pressures, this is not just slightly high, this is extremely high.
Second, the tools the PBOC is using to loosen money conditions are poor tools to stimulate the economy. The tool of choice so far has been reserve rate cuts which free up cash for banks to lend out for investment. This may provide a short term and targeted boost to GDP but it does nothing to lower capital costs for firms. Additionally, this is only exacerbating the problem driving deflation to begin with surplus capacity. The PBOC is trying to boost the economy but pushing credit and investment but there is too much credit and investment to begin with, so additional stimulus here only makes things worse. Furthermore, this is clearly designed to target specific GDP boosting projects not help the largest number of firms and the price they pay for capital. In short, the PBOC is clearly choosing to target the wrong problem and therefore uses the wrong instrument.
Third, RMB internationalization implies a structurally higher demand for money in the rest of the world, something the PBOC appears not to have realized yet. Releasing capital controls in China, which it must undertake if it hopes to join the SDR basket, is tricky business. If Chinese demand for foreign assets perfectly matches the rest of the world demand to hold RMB, then the PBOC has no worries. However, more likely is that the rest of the world is more interested in holding a lot more RMB than, even if we just consider central bank demand, expected Chinese demand. Unless China wants to witness a significant appreciation accompany opening up of capital accounts, it needs to significantly loosen money. While the focus has been on capital controls, which is perfectly reasonable, there is also the money supply and price issue to consider. The PBOC seems to be blissfully unaware of the multidimensional world they are entering by internationalizing the RMB and how this is going to impact their money supply and interest rate decisions.
Official estimates are dropping and state media is talking about the coming economic rebound so there is clear recognition that economic activity is weak and well below public results. Unfortunately, the PBOC is well behind the curve on addressing the economic weakness in China. Private firms and SOE’s are pleading for lower debt costs. What seems puzzling is that the PBOC recognizes the importance of lower interest costs, hence their forced restructuring of provincial government debt, but they have clearly chosen a different path to the larger economy. There is no good explanation for the continued credit and investment push when that isn’t the problem that needs help and actually only worsens the existing issues.