HOW MONETARY SELF-CONFIDENCE GIVES CHINA A LEAD ON THE US

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By Paul Cavey
Monday, August 04, 2008
  

  
Officials
in the US must be jealous. Recent events suggest China's monetary authorities have more credibility than the Federal Reserve. Attempts to talk up the US dollar have been unsuccessful because the markets do not believe interest rates will be raised in the face of a troubling economic outlook. China's monetary policy is similarly constrained, albeit because of the perception of exchange rate undervaluation rather than weak growth. But Beijing has been extremely successful in promoting the idea that policy is tight.

To confirm this, ask ordinary people, speak to global investors or scan media reports. And, of course, “tight” is a condition clearly understood and usually not welcomed by the asset markets. The big sell-off in the Chinese stock market, the start of which can be timed almost exactly to the shift in government rhetoric at the end of last year, suggests as much.

This belief was on show again when the most recent rise in the reserve requirement ratio triggered another particularly sharp leg down in equities.

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Where, though, is the evidence that policy has been tightened? The reserve requirement ratio, for example, is specifically designed to control lending growth. Judged in this light, and particularly in China, it has much more bark than bite: the central bank has raised reserve requirements five times in total this year and annual credit growth has slowed, but only from 18 per cent to 15 per cent. The reason is that the deposit base is being continually inflated by China's accumulation of foreign currency, an inflow that suggests the more rapid appreciation of the currency this year has added to China's problem of excess liquidity rather than tightening it up. And this inflow has made Beijing reluctant to raise interest rates, with the result that real rates have been more negative this year than last.

Don't get us wrong. This is not a criticism of economic policy in the past few months. The great con – “the guiding of expectations” in the proper jargon – is one of the main ingredients of successful central banking. This is because the use of rhetoric is a lot less disruptive for the economy than the adjustment of real monetary tools. For example, with such a weak financial system and economy, raising rates is probably the last thing that Ben Bernanke would want to do right now. This has been exactly the reason for the recent volley of rhetorical support for the dollar – which if successful could have capped commodity prices, and so eased the inflationary threat in the US.

In the US, the campaign of talking up the dollar has had little impact. All the talk in China, by contrast, seems to have been much more effective. Interest rates have not been raised but savers are acting as if they have been. Despite negative real interest rates, money is rushing back into bank savings deposits. In the most recent survey from the People's Bank of China, 50.5 per cent of respondents thought prices would rise in the third quarter of 2008 – which may seem a lot but is hardly changed from a year earlier, and still leaves 50 per cent of respondents saying they do not think prices will rise.

Expectations matter because they are self-fulfilling. With credit growth under control and savers leaving their money in the bank, growth and domestically produced inflation should ease in the coming months. Indeed, the decline in inflation expectations has been so sharp that many investors are worried that the Chinese economy will fall into a downward spiral. This would play out primarily in a sharp weakening of real estate as declining transactions rob developers of finance.

With real estate construction such an important engine of demand, and exports faltering too, the risks to growth right now are on the downside. But the domestic demand slowdown is the flip side of inflationary expectations being under control. As a result, Beijing's next policy move is likely to be towards loosening, with rhetoric shifting away from tightening towards the need to support growth. This will be good news for asset prices. It is only threats of tightening that have weighed on markets over the past six months. The underlying liquidity that caused all the excitement last year is as abundant as ever.

The writer is head of China economics, Macquarie Capital Securities