China's Monetary Policy Spirals Out of Control

Are Chinese officials about to panic and rein in the reckless bank lending that has fuelling nascent bubbles in local real estate and equity markets, and indeed artificially boosting commodities such as copper? While investors have cheered China's latest Q2 GDP growth of 7.9% as evidence of the country's policy success, they may be missing a hugely destabilizing spiral in monetary policy that is generating it. The country looks set this year to generate new bank lending equivalent to over 30% of GDP, or twice official targets, while money supply is growing at an annualized 26%. That's enough to make even Alan Greenspan in his bubble blowing heyday blush, and bubbles are blowing aplenty in China.

The quality of most of these rapid fire loans dictated by Beijing is surely abysmal. About $170 billion of Chinese bank loans are estimated to have been funneled into the Shanghai stock market in the first five months of 2009, or 20% of the total new loans banks made in that time period. Is it any surprise that China has just surpassed Japan to become the world's second largest equity market, and the best performing this year? I suspect another large chunk of that lending has found its way into speculative commodity stockpiling, as well as the real estate market. It's a bit rich that Chinese officials are criticizing US economic policy when they are essentially following the easy money credit boom model in order to forestall a cyclical economic recession. China can certainly achieve its talismanic 8% growth target by throwing vast resources into mechanical short-term growth objectives, but the question is whether these policies are sustainable or simply delay the necessary re-balancing of the economy away from manufacturing and infrastructure investment toward domestic consumption. Investment productivity is appalling, and has been declining for a decade; it is very likely much of the stimulus spending will be a total waste. Far from 'leading' a global recovery (unlikely anyway as it only comprises 8% of global GDP), China will be among the last countries to escape from the effects of the global crisis, being trapped in a deflationary trap of chronic export overcapacity as its foreign consumers deleverage over the next few years. It seems doomed to repeat Japanese policies of the early 1990's, which left that country carpeted in concrete but still mired in recession.

Meanwhile, foreign reserves surged to a record US$2.13 trillion at the end of June making it likely that speculative capital is flooding in to bet on rising asset prices and a quick economic recovery (and even an eventual Yuan revaluation). Most of the increase was driven by the very large trade surplus and declining but still high net FDI inflows, plus of course returns on the existing overseas portfolio but speculative capital betting on a Yuan revaluation is back for the first time since last Summer, evading strict controls on the capital account. Despite often confused media commentary on the dollar and China's role in its fate, China doesn't fund the US fiscal deficit; it funds the US current account deficit, and it has no choice but to fund it because of the dollars generated by its trade surplus with the US which it doesn't want to repatriate to avoid boosting the Yuan. Simplistically, if the US wants China to buy, say $500bn of new bonds, all it has to do is ensure that the US runs a $500bn trade deficit with China that year. Reserves rose US$178 billion in the second quarter, the biggest quarterly increase on record and up from the US$1.95 trillion Yuan at the end of March.

So called 'hot money' flows, notably via Singapore and Taiwan (via falsified trade passing through the current account) intensify Chinese growth in the short term, even as they complicate the PboC's job. The PBoC must recycle the net surplus on the current account and the capital account and with the very high current account surplus, China is creating a huge amount of domestic money from that source alone. Many commentators rightly worry about the Fed's exit strategy from current policies, but China's future policy options are even more ominous. The Chinese economy right now is enjoying a huge sugar high created by the combined effects of a lending boom, money supply growth, and speculative capital inflows, as well as nearly $600bn in fiscal spending, and the asset bubbles all these are helping to generate. However, as the consequences of current policies come home to roost in 2010 and beyond, from soaring bank write-offs to inflation, China will likely become the problem, not the hoped for solution. Any sudden reversal in official policy (eg by requiring higher bank reserves) will have negative implications for Asian equities and commodities such as copper and oil.

Disclosure: None

Comments

[CautiousInv...:]

I t might be important to note that lending in first half of 2009 increased 300% from the prior period of 1H2008. At this pace, sounding lending guidelines and prudent risk management practices cannot be enforced.

With the Shanghai having a P/E ratio of close to 50 and an earnings growth rate of 10%............yielding a PEG ratio of 5, it is safe to say it is a highly over valued market that has only one way to go.

Jul 28 11:51 AM

[Poborsky:]

China will fund the US while it is in their interest to do so. Strong countries are ones that build an economy on export manufacturing not ones that encourage the population to buy plastic widgets with credit cards. The Chinese have been purchasing hard assets with dollars while the values are relatively reasonable and the dollars still have some face value. When commodity prices go through the roof China will be pulling all the strings on the US puppet.

Jul 28 11:56 AM

[Dave Wrixon:]

This article is nonsense. The Chinese were excercising very tight monetary control until the US bubble burst. It was not a Chinese bubble. Not only were they using Interest Rates to prevent their economy overheating but they imposed very high banks reserve ratios by any standards, but I think if you check up even though things have been significantly relaxed Interest Rates and Reserve Ratios are far higher than anything in the West, and the Government debt is negative, meaning they actually have money to spend if they so wish. I am not sure how you find the nerve to even begin making comparisons with the US, let alone chastising them for being spendthrift. Frankly, you haven't a clue what you are talking about. This is about change in World order and by the end of the next decade China will outgrow the US let alone Japan. This could happen as early as 2015. Those that are talking about the possibility of 2050 frankly have their heads up and their asses and don't understand how global markets work in the first place.

Jul 28 04:34 PM

[Dave Wrixon:]

And when you talk about quality of loans, it is much easier to make high quality loans when the majority of the public are actually solvent. Finding credit-worthy borrowers in the US is a nightmare unless you cook the books.

Jul 28 04:38 PM

[Dave Wrixon:]

I would also hazard a guess that the penalties of defaulting on a state bank make that option much less attractive than in the West.

Jul 28 04:39 PM

[coreopsis:]

I second the motion; this article is incredibly ignorant which is in a long line of articles predicting the collapse of 'Red China' -- some 60 years of broadsides. Interestingly, as the result of the Internet whereby anyone can set themselves up as an 'expert', Maher is well below par on understanding economics (deficit=new Treasury purchases). As long as the US has this level of confusion, it's safe to assume that as a country it will never regain its dominant position. That's the best scenario. Is Maher and his ilk a portent of serious decline in America?

Jul 29 09:55 AM

[Tony Daltorio:]

Dave Wrixon has it exactly right - the article's author is without a clue!

The bubble and the bad loans continue to be in the US. And what an insult - to compare Chinese monetary policy to the Fed's manic ploicy of printing trillions of dollars for Wall Street.

Jul 29 02:38 PM