Chinese acrobats are among the best in the world. So are Chinese illusionists, and Beijing will need both their skills to convince markets that last year’s rapid growth of money and credit can be tamed without sacrificing long-run growth.
After achieving real GDP growth of 8.7 percent last year, China’s economy is expected to grow by 9–10 percent this year. Some of that growth is due to sleight-of-hand accounting—for example, counting disbursements for investment projects as part of GDP, even if those projects haven’t started yet.
Meanwhile, the real inflation rate may be higher than official price indexes, therefore overstating real growth. Such a lack of transparency, coupled with the grip government officials still have on the allocation of investment funds, offers ample opportunities for meeting growth targets. Indeed, it seems clear that China has slid back toward central planning and away from market liberalism since the beginning of the global financial crisis.
The large, multiyear, fiscal stimulus package announced in November 2008, which came to Rmb 4 trillion (about 14 percent of GDP), was followed by massive increases in bank loans in 2009. Bank lending grew by more than 30 percent, with new loans reaching about Rmb 10 trillion, while the dollar carry trade added fuel to the fire with speculators borrowing at low US interest rates and investing in Chinese assets.
This year, the People’s Bank of China (PBC) has slowed money and credit growth, but monetary policy is still described as ‘moderately loose’ and bank lending is expected to grow by about 18 percent. The problem is that local authorities want to complete investment projects and are using implicit guarantees to obtain credit via special investment vehicles. Bank loans are being collateralized by land and other assets ‘owned’ by local governments.
Although the PBC has increased reserve requirements to sterilize excess liquidity, the demand for new credit is still strong. If interest rates are increased, capital inflows will fuel the monetary base. There’s a limit to the PBC’s ability to sell bills into the market and as long as the PBC must accumulate dollar assets to peg the renminbi (also known as the yuan) to the dollar at an artificially low level, there can be no independent monetary policy. Flexibility is provided not by a free-market interest rate mechanism but by administrative measures and capital controls.
Financial repression is a hallmark of China’s market socialism, with one control spawning others. Without market price signals—in the form of competitively determined interest rates and exchange rates—and the free flow of capital, China can’t become a world-class financial center.
In addition to this, it should be borne in mind that markets without private property rights are an illusion. Inherent in property rights is the free flow of information, yet the absence of the rule of law to protect the rights of individuals and their property means China cannot have real capital markets, only pseudo markets. With the huge increase in money and credit during 2009, poor risk management, and the difficulty of disciplining state-owned banks and state-owned enterprises, China now faces a major challenge—namely, how to avoid a sizable increase in nonperforming loans and improve the allocation of capital.
The too-big-to-fail problem is endemic in China’s state-directed financial sector, while moral hazard is rampant with the underpricing of risk. Errors are accumulating, and the longer Beijing waits to address them, the more costly it will become to fix them.
Foremost is the issue of the undervalued yuan. Foreign exchange reserves now total $2.5 trillion. It makes no sense for a capital-poor country like China to be a net exporter of capital and China needs to normalize its balance of payments by increasing domestic consumption and allowing capital freedom. Making the renminbi convertible on the capital account and allowing greater exchange-rate flexibility would help China achieve a more balanced growth path. More importantly, it would widen the range of choices open to the Chinese people and increase their wealth.