January 12, 2010 (Erwan Mahe - OTCex Group)
It is with unmitigated pleasure that I observed this morning the gelling of a phenomenon relating to Chinese monetary policy which we have been following closely for some time now.
According to Mundell's incompatibility triangle, the following three phenomena cannot coexist in a country:
fixed currency (yuan's peg to the dollar) autonomous monetary policy (which is the difficulty for China) free flow of capital.
In an effort to maintain relative monetary policy independence, while pegging its currency to the dollar, China has long been trying to regulate capital flows (outflows), thus, trying to fight against a natural movement for a country with a chronic current accounts surplus.
The problem is that such restrictions lead to an accumulation of capital inside the country which, when combined with the administered wave of credit since the beginning of the recession, creates dangerous asset price bubbles (real estate and capital expenditures, classical phenomena described by Hyman Minsky), while generating huge over-capacity in the production of goods for export.
We are thus confronted with two merciless consequences for local and regional economies:
- a domestic inflation bubble on virtually all assets (real estate and capital investments). This props up both local and foreign stock markets, given the sales of investment goods generated by foreign firms in China. This also accounts for a good part of the hike in commodity prices.
- Galloping deflation in the world (exported), fuelled by over-investment in the domestic market, and the continued abundance of cheap labour.
All in all, there are only two ways that China can fight these problems:
- Either it carries out sufficiently strong one-shot currency revaluations while simultaneously setting up a modern financial markets system, which is the country's next logical step to converting its economy into a modern capitalist economy;
- Or it can continue its administrative tinkering, as it did this morning by hiking bank reserve ratios by 50 bp to 16%, the first increase since it lowered this ratio from 17.50% to 15.50% between July and December of 2008.
This move should remove about 300bn yuan in liquidity from the banking system.
The problem is that history shows us that financial institutions always find ways to circumvent this type of administrative measures (securitisation).
It does not make a whole lot of sense to hike these ratios now while maintaining an accommodating monetary policy throughout 2010!
For those curious minds, check out this enticing interview with none other than Mr Mundell, who is very concerned about the Chinese triangle, and a 2003 study on chinese currency rates undertaken by Persée, which is as relevant as ever today.
Yesterday, we highlighted the divergence in US and Chinese credit markets, but Japan added gist to the mill this morning with the publication of a 1.2% plunge in the bank lending balance on an annual basis (vs an expected +0.1%) and a contraction on the commercial paper market for the sixteenth month in a row.
And if we limited ourselves to city banks (excluding the less cyclical rural banks), the contraction comes to -3.1% on an annual basis.
This constitutes an additional symptom to the ailing Japanese economy, and increases the likelihood of a FAR MORE AGGRESSIVE QE.
As for possible remedies, check out the 22 July 2009 Thaler's Corner (Europe is struggling and the awakening of the ultra-Keynesian, Mr Svensson), the text written by Paul Krugman in 1998, which is the subject of the latest Focus note of PIMCO's Mr McCulley chez PIMCO, who is always a pleasure to read.
In response to numerous requests, I provide below some interesting links on this subject from last summer:
‘Japan’s Trap’ (The credible promise to be irresponsible) -- Krugman in 1998
‘Thinking about the Liquidity Trap’ -- Krugman 1999
‘Deflation: making sure it doesn’t happen here’ -- Bernanke 2002
‘Some thoughts on monetary Policy in Japan’ -- Bernanke 2003
‘How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible’ – IMF - Gauti B. Eggertsson --2003
’Monetary policy with a zero interest rate’ – Svensson 2009
I know, I know, that's a whole lot of reading, but how else can I seek revenge for all those snide remarks at home about spending all my free time ensconced in reading?
Sans rancune, votre courtier favori…
Feel free to contact me at any time.
Erwan Mahé - Asset allocation and option strategy
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