Policies China’s government is willing to impose don’t work, while the policies that might work cannot be implemented so long as speculative capital continues to pour into the country, says Larry Brainard. More than ever, the only way out of this bind is through a substantial appreciation of the currency
Since last December Beijing officials have taken every opportunity to highlight their tough line on fighting inflation. The evidence suggests they have little to show for their efforts – during Q1/08 China’s CPI (consumer price index) averaged 8.0%, up from 2.7% in the same period last year.
During 2007 China’s domestic savings glut found an outlet in domestic and foreign equities, fuelling a massive stock market bubble in Shanghai and Shenzhen stocks and a brief spurt in inflows into QDII (Qualified Domestic Institutional Investor, a capital market investment scheme) funds for investment abroad. This all came to an end in Q4/07 when the government’s efforts to talk down the equity and property markets succeeded all too well.
Personal savings glut
Deterred from equity investments, individual savings have nowhere to go, other than bank deposits and spending on goods and services. Bank deposits pay a sizeable negative real return, currently minus 3–4% for one-year deposits. Even though personal savings have historically shown steady growth, this year there has been a surge in personal savings deposits.
Last year savings by non-financial corporations substantially outpaced the growth in personal deposits. This picture has now changed radically. The tight curbs on bank lending imposed in January by the People’s Bank of China (PBOC) have forced corporations to draw down deposits to meet liquidity needs. As a result, the growth in corporate deposits has slowed compared with last year.
Meanwhile resident or personal deposits have soared, rising at a rate over five times faster than in 2007. Despite negative interest rates, this growth reflects both individuals’ disenchantment with the equity market as well as the lack of alternative outlets for their savings. Last October individuals were clamouring to get their money into QDII foreign investments; now investors are adding to yuan deposits, despite sizeable negative real returns.
With all this liquidity pouring into investments that promise a steady erosion of individuals’ purchasing power, it should not come as a surprise that consumer spending is gaining momentum. In effect, what was once a stock market bubble is now being converted into an inflation bubble – excess domestic liquidity is spilling over into increased consumption spending and hoarding. Government policies of price controls on several key commodities, such as fuel, are worsening the situation by feeding inflation expectations and shortages.
The PBOC’s efforts to control inflation via caps on bank lending do not hold out much promise of working. Tight controls on lending are, to be sure, having a noticeable impact on corporate liquidity, but the growth in personal deposits more than makes up for the lack of growth in corporate deposits. The monthly growth in total deposits (including other deposit categories, such as government and rural accounts) shows strong growth, twice the growth rate in 2007.
Capital surge
An additional development feeding the growth of China’s liquidity bubble is the growth in the unexplained residual in the balance-of-payment flows – what is commonly, and misleadingly, termed hot money. In reality, such inflows are quite diverse – they include capital from overseas Chinese, cash inflows into yuan investments by domestic corporations minimizing their exposure to a weakening dollar, as well as pure speculative flows. During 2007, unexplained capital inflows averaged an estimated $10 billion per month. So far in 2008 such inflows accelerated to an estimated $34 billion monthly inflow, drawn by expectations of a revaluation of the yuan.
These estimates were published by Logan Wright, a Beijing-based analyst with Stone & McCarthy. Using detailed detective work, Wright comes up with an estimate for so-called hot money inflows in the range $81–147 billion for 2007 and $80–120 billion for Q1/08. The wide range highlights the difficulty in pinning down a more specific figure, given limited detail on valuation adjustments, the timing of transfers of foreign reserves to the China Investment Corporation and the effect of reserve requirements imposed on the banks in foreign currencies. The midpoint of Wright’s range gives us our estimates of $10 billion average monthly inflows in 2007 and $34 billion in Q1/08.
Hot money
So-called hot money inflows are a major worry for policy-makers, judging by the frequency with which the subject has been broached by Chinese officials. Li Deshui, former head of China’s statistics agency (NBS), said that speculative inflows were a major contributor to the country’s problems with excess liquidity. Li’s speech to the early March meeting of the Chinese People’s Political Consultative Conference, a senior government advisory body, cited research that the total amount of hot money now stands at $500 billion. Zhao Baoling of the State Information Centre, a research unit under the planning agency (NDRC) was quoted in China Daily saying that an estimated $80 billion in hot money inflows were recorded in the first quarter, not far off our estimates.
Wright also turned up a curious nugget of information that suggests these estimates may be understated. Inflows of FDI during the first quarter were $27.4 billion, up 61% over the same period in 2007. Yet the Q1 data on foreign sourced capital for fixed investment fell 6.5% over the same period. While there is undoubtedly a lag between the flows measured by the two numbers, this divergence raises the suspicion that some of the flood of FDI is really hot money in disguise.
Smoke and mirrors
Part of the difficulty in dissecting FX inflows into China is caused by policies that understate the growth in the country’s official FX reserves. Since August banks have been required to meet periodic increases in reserve requirements in dollars rather than yuan. The PBOC provides the banks cover for the currency risk, either via a currency swap or option (details are lacking), but the net effect is to take such sums out of official reserves and move them into the PBOC’s balance sheet entry for ‘other foreign assets’.
Boxed in
China’s leadership now finds itself boxed in. Policies that work in fighting inflation, such as higher interest rates, will attract even more capital inflows, thus exacerbating the PBOC’s efforts to control domestic liquidity. And given expectations of more rapid yuan appreciation, initiatives to stimulate capital outflows are likely to fall flat.
The bottom line is that policies the government is willing to impose don’t work, while the policies that might work cannot be implemented as long as capital continues to pour into the country. Increasingly, the only way out of this straightjacket is via a substantial appreciation of the yuan, not as the best option, but as the least bad option, now that previous opportunities to control the growing domestic liquidity bubble have fallen by the wayside.
Larry Brainard is chief economist for Trusted Sources, an investment intelligence service