China’s dual economy could falter

Forget about Andrew Jackson (on the $20 bill); it's Chairman Mao who's flooding the market!  China's loose monetary policy is creating a bubble waiting to burst.  Source:  Google Images
Forget about Andrew Jackson (on the $20 bill); it’s Chairman Mao who’s flooding the market! China’s loose monetary policy is creating a bubble waiting to burst. Source: Google Images

China has a dual economy.  There is the modern coastal economy oriented for export that has exploited China’s comparative advantage in labor-intensive manufacturing to generate US$2 trillion in fx reserves; and, there’s the rest — the government-directed economy of bank lending, state-owned enterprises, and massive, massive investment in real estate, roads and other infrastructure.  With the onset of the Great Recession, China loosened monetary and credit policies, with the government directing banks to lend to anyone willing to spend (and unlike in America, Chinese banks listen).  Figures show a massive increase in credit (see today’s CreditSuisse note below). 

It is probable, that not unlike before the Asian financial crisis of the late 1990s, much of the recent investment has gone into projects with negative returns.  Moreover, the credit boom has inflated a bubble in real estate and financial asset prices that is waiting to burst.  Years ago, a bubble bursting in China would have represented a speed bump in the developed world.  Not so today, when China’s heft rivals Japan’s for the number two largest economy in the world.  The Economist this week talks about the bubble in financial asset prices globally, driven by loose money and credit policies everywhere. 

In a very good New York Times article yesterday, the unsustainability of China’s boom was discussed.  First, exports can no longer drive growth in a global economy where developed countries are licking their wounds.  Second, the misallocation of resources that comes from unrestrained credit growth usually leads to bubbles bursting, and in some cases, i.e. Japan, to lost decades of growth.   One only has to recall the villages of empty skyscrapers in Thailand in 1998 to worry about the consequences of unrestrained credit growth in emerging markets.  But again, Thailand in 1998 was a speck on the butt of the elephant; China today is the elephant.

China note from CSFB 1/12/09:


Bank lending rose sharply to nearly RMB600bn during the first week of this year,

according to Reuters. If confirmed, this would be more than the average monthly lending of RMB366bn during H209 and in line with the record-breaking lending posted in January 2009. The five largest banks apparently lent out only about RMB180bn during the period, so it appears that the smaller banks have been making an aggressive push. The smaller banks exhausted their lending quota last year, hence all their pent-up lending transactions had to be made after the new year. It has also been a Chinese tradition in recent years to complete the biggest and highest quality deals at the beginning of the year, in anticipation

of competition and forthcoming government tightening.


We believe that this RMB600bn of lending in one week is a surprise to the

government and may have policy implications. With concerns about a double dip in the US and Europe and uninspired private investment, Beijing has been dovish regarding its monetary policy and soft handed in terms of dealing with banks’ excessive lending. The policy strategy is to keep overall lending policy loose, but to tighten the criteria for shortterm lending and second home mortgagelending. Beijing hopes this will encourage bank lending to the real economy and hence improve the job market’s prospects. We believe the surge in lending is more than Beijing has bargained for and perhaps suggests that relying on banks’

voluntary self-restraint is probably not enough to slow down lending consistently. In our view, this will probably not result in earlier rate hikes, as interest rates are not an effective policy tool, although symbolically significant. The government is also concerned about ‘hot money’ inflows if the rate gap between the RMB and USD widens. We think that the People’s Bank of China is more likely to push up the reserve requirement ratio, which would be more effective in reining in lending activity by the smaller banks. After the collapse of Lehman Brothers, PBoC lowered the reserve requirement ratio for the small banks from 17.5% to 13.5% (and for the large banks from 17.5% to 15.5%). Should lending continue at such a fast rate, we would expect the reserve ratio to be raised after the Chinese New Year (14 February), possibly by 100bps for the smaller banks and 50bps for the large banks. A loan quota system similar to what was seen during 2005-2008 would probably be introduced no later than March.

In related news, PBoC sold one-year bills at a yield of 1.84% in open market

operations today. Following last week’s 3-month yield jump, the central bank’s 1-year bill yield has risen 8bps now, the first rise since August. In our view, the central bank is attempting to guide the market to a gradual normalization in commercial interest rates.

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