Understanding Chinese Monetary Stimulus

Includes: FXI, GXC
by: Evan Schnidman

The first thing to note about Chinese monetary policy in that the People's Bank of China (PBOC) fundamentally targets economic growth. This dramatically differs from most other central banks which target price stability (inflation) and, in some cases, as in the U.S., employment. Since growth is an outcome variable that can only be successfully targeted in a planned economy, the entire Chinese system looks very different from what most outside observers are used to. It is also important to point out that central planning for an economy in the modern era of global trade is virtually impossible and the result looks a lot more like North Korea, than like China. So, we begin from the premise that China targets growth, but does not have a completely planned economy.

From this premise it is easy to see why China has sustained pressure to keep the value of its currency low and promote export growth over the last decade. Keeping the Yuan depressed helped sustain manufacturing growth and promote demand for cheap Chinese goods around the world. As this demand grew, so did the Chinese economy thereby allowing the PBOC to meet its growth targets. But with the financial crisis in 2008, and the subsequent European debt crisis, global demand for Chinese goods dropped precipitously and the PBOC was slow to respond.

The question of why the PBOC was slow to respond is an interesting one and an optimistic geopolitical eye might even suggest that they wanted to retain favor with the U.S. government and were thus devoted to allowing their currency to rise in value. A more cynical eye might suggest that the PBOC overestimated domestic demand and underestimated the devastating effect of continued economic turmoil in Europe and a slow recovery in the U.S. Either way, the result is that the Chinese GDP growth dropped from over 14% in 2007 to under 8% in 2012.

Recent Policy

In an effort to combat the slowdown, the PBOC issued a record cash injection and lowered bank reserve requirements to simulate their economy. Instead of weakening the Chinese currency to promote export demand, the Yuan hit a record high just two days later. Some might see this as underlying confidence in Chinese economic growth, but if this were the case, the PBOC would not have had to pursue another cash injection just two weeks later. Again, this was to no avail as the Yuan hit another record high. All the while, Chinese inflation has been slowing, exports falling and every indication is that the PBOC will pursue even greater stimulus in the final months of 2012.

Fundamental Flaws

One of the reasons why Chinese growth has slowed so dramatically, even in the face of significant monetary easing, is that processing exports from Korea and Japan is big part of Chinese trade. The continued territorial dispute with Japan has weakened this component of the Chinese economy. Moreover the change in leadership in China has created some (albeit not very much) uncertainty about the future of policy there, when added to the U.S. election and the anti-China rhetoric from American leaders, Chinese economic growth prospects are diminished. Nevertheless, unlike the gridlocked U.S. political system, the Chinese government has been able to pursue some internal infrastructure spending that will help spur economic growth.

Ultimately, the biggest problem in Chinese monetary policy (or economic policy more broadly) is not that they target an outcome variable in an increasingly uncertain economic climate or even that they have been undervaluing their currency for so long that their monetary policy is less effective (Chairman Bernanke suggested this in his October 14 speech to the IMF). The biggest problem the PBOC is having is that everyone else is doing the same thing, only better.

The Fed, ECB, Bank of Japan, Bank of England etc. have all engaged in significant monetary easing and/or stimulus this year. Save for the ECB, all of these banks have more control over their respective economies than does the PBOC because they have established credibility in an open free market. Moreover, as the Bank of England has repeatedly demonstrated, they are willing to provide an enormous amount of stimulus (the BOE has provided more per-capita stimulus than the Fed has) and this drives down the relative value of their currency and bolsters the Yuan, even as the PBOC tries to ease but cannot keep pace.

Bottom Line

China's economy has grown too big for the PBOC to have a significant effect without taking much bigger, bolder action to stimulate their economy. The trouble is, China's economy is still growing 4-times as fast as the U.S. economy and they are on the verge of being officially declared a currency manipulator by the U.S. government. So, any action to ease further could end up backfiring and destroying the Chinese export sector. This leaves the PBOC to keep kicking the can down the road with small, targeted stimulus measures as they hope that the global economy recovers fast enough to revive their export sector to its pre-crisis glory. Investors should see this as an opportunity to hedge on the rising value of the Yuan until and unless the PBOC throws caution to the wind and pursues massive monetary stimulus.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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