The money supply and its impacts in China

Yu YongdingInstitute of World Economics and Politics, Stockholm 12 Sep. 2013

Is exogenous supply side policy the applied format in China？

• “The dominant monetary theories between the exogenous and endogenous creation of money. While endogenous demand driven creation has become the most accepted way in Western countries, exogenous supply side policy is the applied format in e.g. China.”

• Is the underlined proposition right? Not really.

the exogeneity of money supply

• the exogeneity of money supply is conditional on – the exogeneity of the monetary base and – stability of the multiplier

• In China the two conditions for the exogeneity of money supply cannot be met entirely.

The difficulty in controlling the monetary base

• The expansion of China’s monetary base comes overwhelmingly from the increase in foreign exchange reserves

• The PBOC has to use sterilization policy to offset the influence of the increase in foreign exchange reserves on the monetary base– selling CBBs – raising RRR– change benchmark interest rates of commercial banks

• The control over monetary base is passive, imprecision in terms of timing and quantity, unstable, and causes misallocation of financial resources

Instability of the monetary multiplier

• Pro-cyclicality – When the economy is in deflation, the monetary

multiplier tends to fall (1998-2001)– when the economy is overheating, the multiplier

tends to increase• Unpredictability

Implications

• Because of the endogeneity of the money supply, the PBOC has to give up targeting the growth rate of broad money, even targeting the credit

• Bench-market interest rates sooner or later will become the intermediate target of the PBOC

How has China’s monetary policy been conducted?

• Growth rate of M2 is much higher than that of nominal growth rate of GDP

• China’s inflation has been relatively low over the past three decades

• China also experienced boom and bust cycles, but fares much better than most EM countries

The exponential expansion of the balance sheet of the PBOC

Rapid growth of monetary aggregates

The Highest M2-to-GDP ratio in the world

Liability side of the banking system including the central bank liability, stock variable.

highest credit-to-GDP ratio in the world

Asset side of banking system. Debt here is a stock variable

the transmission from the money supply to real GDP and inflation

• Compared with the endogeneity of the money supply, the transmission failure from the money supply to real economy is a more serious problem facing the PBOC– during and in the wake of the Asian Financial Crisis,

despite the fact that the growth rate of M2 is significant higher than that of nominal GDP, both real GDP and inflation refused to budge.

– In boom period, despite the monetary tightening, the economy can still suffer from overheating. The inflation and asset prices continue to rise

The chains of causality from the monetary base to the real economy

• Monetary base money supply? real economy and price

• Even if the supply of money is exogenous variable, the availability of means of exchange and store of value (nominal loanable funds) is undecided, unless taking into consideration of the demand of money, which seems not dependent of the supply of money

• The missing link of the chains of causality is social finance

Total Social finance

• TSF is a term coined by the central bank to monitor aggregate financing apart from yuan bank loans. It is a flow variable including RMB Loans, Foreign Currency Loans (RMB), Credit Loans, Entrusted Loans, Undiscounted Bankers' Acceptances, Corporate Bonds, Domestic Equity Financing of Non-financial Enterprises

• Failure in monetary targeting and credit targeting, the pboc tries to use the so-called TSF as a reference for the implementation of monetary policy

The decrease of the share of Bank credit in “social finance”

The implication of the lowering of share of credit in total social finance

• The share of bank loans in TSF fell from 91.9% in 2002 to 52.1% in 2012. Particularly in the last four months, the ratio on average was less than 40%. In December, it was only 28%.

• the trend fits the goal of financial reforms to reduce the economy’s excessive reliance on bank loans.

• What at issue is that the pricing of nonbank credit financial products didn’t properly factor in the risk of the underlying projects.

• This is especially related with shadow banking activities• But the shadow banking activities still have some way to go to

cause a financial crisis

A puzzle: very high growth rate of the money supply vis-à-vis relatively low inflation

• Growth rate of broad money is much higher than that of nominal GDP persistently

• How can it be?• What are the implications?

China’s inflation over time

China’s inflation over the past 30 years

China’s property price

Source: property China

A tentative answer• High saving rate of the household sector

– Money is no just means of exchange– But also store of value– With a relatively underdeveloped capital market, saving deposits are the dominant

form of store of value• Asset bubbles reduce the inflation pressure on the real economy

– When money is chasing assets rather than goods, inflation pressure will be reduced, ceteris paribus.

– House price growth Is extreme fast. House essentially is a durable good. If property prices have been incorporated in CPI after some adjustment, China’s inflation could be much higher.

• In taking off stage, a relatively high growth rate of money supply is reasonable. But following the maturity of the economy, it is no longer true.

• But, loose monetary policy allows leverage to increase excessively, the high leverage increases the likelihood of financial crisis