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China in monetary denial

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denial_1 April 18, 2011 (Erwan Mahe) I'm leaving the PIGS nation topic for tomorrow, when I hope to offer some much needed cool-headed analysis is a sea of hot-headed commentary.

Inflation in China; the solution is not administrative buy monetary (interest rates and currency)

China decided this weekend to increase the reserve requirement ratio of commercial banks by 0.50 points to 20.50%. This move helped drag down world stock indices today, which really didn't need the "help", especially in Europe.

Bear in mind that reserve requirements stood at just 8% in 2006! With the exception of the big scare of Q4 2008, when it was briefly reduced one percentage point, this ratio has been rising ever since. As you can see in the graph below, it rose to as high as 16.50% and 15.50%.


This monetary tightening via regulatory methods has come just two weeks after a hike in key interest rates. It should continue for some time to come, as noted by PBoC governor Mr Zhou.

  • “Our monetary policy will continue to move from moderately loose to prudent.”
    “The trend will continue for some time.”
    The government will “remove the monetary factors that are related to inflation.”
    No “absolute” limit on how high reserve requirements can go.

This tightening of the monetary screws is driven by the current inflationary surge in the Middle Kingdom, with March inflation at +5.4% YoY, the highest since July 2008.

It is a bit more ironic that Chinese leaders always strive to put the blame for the price acceleration in China on the US Fed, given that they they are entirely responsible, as can be seen in the graph below!

In the graph, CPI, illustrated by the white line, begins taking off in late 2006 and peaks at +8.7% in Q1 2008. This steep price growth convinced China to allow its currency to appreciate faster against the dollar, from 2% in H2 2005 to over 10% in 2008.

The crisis in 2008, which resulted in GDP falling from 14% at year-end 2007 to +6% in mid-2009 and in the CPI falling into negative territory (bottoming at -1.8% YoY), spurred a return of the country's old demons, as the government decided to tighten their peg to the US dollar and, above all, encourage banks to flood the economy with loans (yellow line in graph), which sent lending volume up 34% YoY in mid-2009. M2 money supply (orange line) logically followed as it surged 30% YoY!

The CPI logically suffered from the impact of this surge in credit aggregates, which explains why Chinese authorities are trying their best to limit bank lending, but I remain skeptical of their ability to resolve this problem by administrative means.

Moreover, their administrative float of the yuan is not nearly enough to counter inflation (just +4.47% vs dollar since June2010!) and this has resulted in the hike in commodity prices.

  • As long they continue to manipulate their currency's exchange rate and accumulate dollar reserves (now over $3 trillion), their monetary policy will remain a hostage to Fed policy.
  • However, the latter is confronted with an economic situation that leads it to maintain an ultra-accommodative monetary policy.
  • As long as China refuses to achieve monetary sovereignty by letting its currency float, its mercantilist policies will leave it trapped in Mundell's triangle of incompatibility. As time passes, the underlying sources of tension remain unchanged, as I noted in my China report published in January 2010 (

Credit, M2 and CPI in China

As long as they continue manipulating their currency's exchange rate, they will remain hostage to Fed policy!


Just a little sneak preview on tomorrow's Thaler's Corner, with this comment by China Investment Corporation president Lou Jiwei:

  • He is “most pessimistic” about the outlook for Europe, citing concerns about banks’ balance sheets, debt restructuring and sluggish demand.

Asset allocation biases and advised option positions

Still Negative on Eurostoxx, favour wide delta negative put ladders, but with long theta.

Still Neutral to bullish on interest rate markets, given that the correction since the beginning of the year, from 0.90% to 1.90% on 2-year German bonds, seems sufficient for the time being.

Feel free to contact me for volatility curves, skew and calendar tailor-made strategies offering real alpha opportunities!!

Have a good day

Erwan Mahé - Asset allocation and option strategy

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