China in Transition

How Can Liquidity Growth Be Curbed? - Shifting to a freely-floating exchange rate system as the ultimate solution

Chi Hung KWAN
Consulting Fellow, RIETI

In recent years, driven by a rapid expansion of the money supply (or "liquidity") accompanying a sharp rise in foreign exchange reserves, China has shown signs of an emerging asset bubble, with real estate and share prices climbing rapidly. The inflation rate has also continued to rise. The Chinese government has been taking steps to tighten monetary policy in order to halt the surge in liquidity, but constrained by the exchange rate policy that seeks to achieve currency stability against the U.S. dollar, monetary policy has failed to produce the desired outcomes.

The mechanism behind liquidity growth and its consequences

China has generated a surplus in its current account - primarily in its trade balance - as well as in its capital account, which reflects the flow of funds. These twin surpluses have exerted upward pressure on the renminbi (RMB). The People's Bank of China (PBOC, China's central bank) has been intervening in the foreign exchange markets by buying U.S. dollars and selling RMB for the purpose of holding down upward pressure on RMB, but this has resulted directly in an increase in the supply of base money by an amount equivalent to that of the foreign exchange reserves (in terms of the RMB). The increase in foreign exchange reserves indicates that the scale of intervention in 2006 amounted to $247.5 billion, or 9.4% of China's gross domestic product (GDP). This year, the figure is even higher, reaching $367.3 billion in the first nine months alone. As a consequence, China's foreign exchange reserves stood at $1,433.6 billion in September 2007. This is the highest level in the world, and China continues to widen its lead over second-place Japan, which at the same point had foreign exchange reserves of $945.6 billion.

The growth in base money has boosted broad money supply (M2) by means of the credit multiplier. Consequently, China's M2 at the end of 2006 reached 34.6 trillion yuan. Calculated by dividing M2 by nominal GDP, the Marshallian K stood at 165%, which is very high in both international and historical terms.

This growing liquidity has pushed up consumer prices as well as asset prices, namely prices of real estate and shares. The sharp spike in real estate prices started in Shanghai and other coastal urban areas around 2002 and has now spread to inland cities. The upward trend in stock prices was triggered by the reform of non-tradable shares launched in 2005. The benchmark Shanghai Composite Index has multiplied almost six times over the past two and a half years.

Inflation is also accelerating, with the year-on-year rate of CPI increase reaching 6.5% in August 2007, its highest level over the last ten years.

Monetary policies

To hold down the surge in liquidity resulting from its growing external surplus, the PBOC has introduced the following three major measures, which are designed to tighten monetary policy or achieve sterilization in a broad sense.

(1) Open market operations
The PBOC has conducted open market operations, specifically selling government bonds and central bank bills to actively recover base money (sterilization in a narrow sense). However, the scale of intervention has become so large that sterilization operations have led to a rapid rise in interest rates, which in turn is attracting further capital inflow, making liquidity control increasingly difficult.

(2) Upward revisions to the deposit reserve ratio

The PBOC aims to control the credit multiplier and the money supply by raising the deposit reserve ratio that applies to banks. It has revised this ratio upwards 11 times since 2006, for an aggregate increase of 5.5 percentage points, to 13.0%. This year alone, eight revisions have been made, hiking the ratio 4.0 percentage points in total. These revisions adversely affect bank profitability as the interest rates the banks can earn from the reserves deposited with PBOC are much lower than the interest rates they charge their borrowers.

(3) Increase in interest rates

The objective of interest rate hikes is to discourage demand for investment, shares, real estate, and other non-deposit financial assets by increasing borrowing costs, thereby easing the upward pressure on consumer and asset prices. Since October 2004, lending rates have already been increased eight times, with the benchmark one-year lending rate rising 1.98 percentage points in total, with an aggregate increase of 1.17 percentage points in five revisions executed in 2007 alone. Meanwhile, to bolster the appeal of deposits and stop the outflow of funds to the stock market, the PBOC has also raised interest rates on deposits by seven times since October 2004, with the benchmark one-year deposit rate rising a total of 1.89 percentage points. Even these aggressive hikes have failed to keep pace with runaway inflation. As a result, real interest rates have followed a downward trend since the beginning of 2006, with real deposit rates falling below zero. Thus monetary tightening so far has been insufficient to prevent further rises in consumer and asset prices.

Transition to a freely-floating exchange rate system as a last resort

The ineffectiveness of monetary policy in China is consistent with the principle of impossible trinity, that no country can simultaneously achieve three goals: free capital mobility, an independent monetary policy, and a fixed exchange rate. China had, for a long time, pursued independent monetary policy while retaining a de facto dollar-pegged exchange rate and by restricting capital mobility (giving up free movements of capital). With capital movements gathering momentum following China's accession to the World Trade Organization (WTO), however, the effectiveness of its monetary policies is declining as noted above. While China shifted to a managed floating exchange rate regime in July 2005, the focus of its foreign exchange policy is still on "management" rather than on "floating." As a result, the severe constraints on monetary policies have remained almost unchanged.

In fact, China's external surplus is the direct result of the PBOC's intervention in the foreign exchange market in a bid to ease the upward pressure on the foreign exchange rate. This pressure arises from circumstances under which the supply of a foreign currency, namely U.S. dollars, exceeds demand as the RMB is undervalued. In the absence of intervention by the central bank, as under a freely-floating exchange rate regime, any imbalance between demand and supply in the foreign exchange market is corrected by fluctuations in the exchange rate. A current account surplus, for example, would inevitably be offset by a deficit in the capital account, or a net capital outflow. As a result, liquidity growth is blocked at the source. Thus shifting to a freely-floating exchange rate system is the most effective solution for curbing liquidity growth. Indeed, it was the rapid growth in foreign exchange reserves and in the money supply starting 1971 that prompted Japan to adopt a floating exchange rate system in February 1973. Likewise, shifting to a freely-floating exchange rate system is now the only remaining option China can adopt today to curb its liquidity surge.

November 1, 2007

November 1, 2007