China attempts to keep the good times rolling through monetary policy

Thursday, December 3, 2015

China may be adopting a policy of monetary sterilization

By Farrokh Langdana, Director, Executive MBA Program & Professor of Finance and Economics

Faculty Blog: business.rutgers.edu/langdanamacro

(This write-up is followed by an excellent overview of digitally-driven consumption in China, by Rutgers Shanghai EMBA, Oskar Helling, for the Finnish Chamber of Commerce, earlier this year).

Monetary sterilization is actually a very sophisticated and complex process by which central banks "juggle" different aspects of monetary growth to simultaneously affect different macro-variables. 

Very simply, in August, 2015, with the U.S. dollar getting stronger, China had to work harder to maintain its currency peg. The dollar appreciated, thanks to massive capital inflow attracted by its "safe-haven" status and by signs of traction in the U.S. economy. Now to just stay at the pegged rate of 6.24 Yuan to 1 $US dollar, China had to buy even more Yuan and sell even more foreign exchange reserves (FX).

This caused its FX reserves to drop, but more importantly it was causing a drag on its economy thanks to the contractionary effects caused by the "sucking in" of the Yuan (decreasing its monetary growth) to keep the peg in place. In short, this was causing China to push its aggregate demand to the left — constricting economic growth. In August, relaxing the peg somewhat took the yuan a tweak closer to its endogenously determined (market determined) exchange rate.

Then in October 2015, China announced its sixth drop in interest rates in one year, and a 50 basis point reduction in its reserve ratios. Both of these point to an increase in monetary growth.

So here comes a monetary expansion à la Keynes; an expansion that will hopefully keep property prices inching up, and the economy pushing forward.  We know that the big infrastructure spending boom is over—as evidenced by the depressed economies of commodity–exporting countries to a slowing China; prime examples being Brazil, Australia and South Africa. 

China is definitely slowing, but private consumption (C) now has some life in it.  The digital/financial revolution in online retailing has been one of the unsung successes of China, and perhaps the growth in private consumption, C, and in housing and the growth in the 2nd and 3rd tier cities will come to the rescue

(Please see below for an excellent overview of the growth in digitally-inspired consumption in China, by Rutgers EMBA alum, Oskar Helling, based in Shanghai. He is Executive Director of the Finnish Chamber of Commerce.)

Back to monetary sterilization (October 2015)...With “one hand,” the People’s Bank of China (PBoC) is expanding money growth to keep its aggregate demand moving to the right and pushing its economy (housing) forward, while with its "other hand" it is sucking in yuan every day to lock in its current yuan to dollar rate. I am not sure if the sterilization is 100% (that is, no final net increase in monetary growth) or some net positive increase, but the reason that the PBoC does not want monetary growth (M) to run rampant is that they don’t want speculative asset price (SAP) bubbles again in the stock market; been there, done that! Hence the tight rein on M (monetary growth).

Outlook for China?  As The Economist magazine put it, "Growth is lower than advertised, but the bottom is not falling out."  The heady and magical days of massive infrastructure growth are over – that was the low-hanging fruit. Now comes the harder Phase 2, driven by private consumption and online to offline (O2O) consumption fueled by hyper-connectivity and ease of payment, health care, water control, updated education, and fixing the "quality of life" challenges that face its urban and rural population.

The explosion of China back into the world has been a once-in-a-lifetime event in human history. Never has a country grown so much for so long. China has always been an economic powerhouse. After a hiatus of 300 years or so, it has come roaring back, an episodic moment in history.

 

Analysis: The realities and drivers of China’s Economy

By Oskar Helling, Rutgers International Executive MBA, Shanghai

As I am writing this, in mid-July 2015, the National Bureau of Statistics announces that the Growth in the Chinese economy was 7.0% in the second quarter of 2015. This is a slight uptick from the 6.8% annualized growth we experienced in Q1. Now we are back at the same pace as at the end of last year. The speed of China’s growth is slowing down a few tenths of a percentage point each year. However, this "new normal" is often misinterpreted in the western context, which is grappling with near 0 –level growth.

Yes, it is technically correct that that the economy has not expanded this "slowly" in about a quarter of a century. However, what is often forgotten – or omitted – in the popular narrative is that only a few years ago we all agreed that the breakneck speed of double-digit growth had to be slowed down before the economy collapsed from overheating. Well… the slowdown we are now seeing is exactly what we all only a few years ago insisted was necessary.

Thus, the Chinese economy is being carefully managed and is maturing through a structural change where private consumption and the service-sector will be taking center stage. Beijing has the advantage of not being constantly distracted by approval ratings, the media, or upcoming elections. The leadership is managing the economy - not letting the economy manage them.

On the other hand, the ruling party is in an uncomfortable position where it has nothing more to win. It can only lose. In a situation like this, one plays against time and aims to secure the status quo. The smart move is thus to be careful and not waste precious "economic ammunition." Should it want to do so, Beijing could easily dig into its tool-kit and whip the economy back up into double digit speed, but this would be utterly foolish and, more importantly, completely unnecessary.

The economy of China will grow on increased consumption. An important driver of this development is the inevitable urbanization drive that will be steered towards the over 600 lesser tier cities in China. Today, only little more than half of China’s population lives in urban areas. To put this number in context, very few developed economies have an urbanization rate below 70%. Therefore, this inevitable movement could translate into the "birth" of roughly a quarter billion new urban consumers within the next two-three decades. These consumers will demand their share of the Chinese dream - apartments, flat-screen TV’s, the works.

Beijing’s challenge is probably not so much in keeping the economy going, but rather, making sure the growth happens where it wants it to happen.

One place where this growth is happening very rapidly is the digital realm. China has become, almost in a clandestine fashion, a top player in the space of mobile e-commerce. We all have heard about Alibaba, Tencent and the Double-11 shopping frenzy that breaks records each year. However, it seems that many observers based in the West have not realized how well developed and how amazingly integrated the Chinese e-commerce applications and payment systems actually are.

While most media rarely forget to point out that Facebook is not available in China, they seldom mention that Chinese consumers are able to, for example, book their flights or taxis, manage their investments, and order their groceries (with delivery within hours) directly from their mobile phone. At face value, none of this is particularly amazing - we can, in principle, do all of this in the West as well. However, what makes the Chinese eco-system special is that payments are totally integrated, eliminating the need to use credit cards or logging into ones online bank. One can even pay at the convenience store by just allowing the cashier to scan the code on ones mobile phone screen. Mobile payments in China are today faster, more secure, and more convenient than cash or plastic can ever be.

While only a few years ago the Chinese social media giants mimicked Twitter and WhatsApp, now the tables have turned. Today WeChat, Weibo and a thousands of other apps are leading the innovation, and developing ever more imaginative ways of connecting the online world and off-line marketplaces making spending ever easier for both urban and rural consumers in China. Add to this that the quality of the domestically developed software is today light-years ahead of what it was just a few years ago.

China will, during the next decade or so, emerge as a world leading digital consumption economy surpassing anything we have seen so far. There seems to be little doubt regarding both the speed and direction of this development. Perhaps the more intriguing question is: Will, by that time, some of the economies that are considered "developed" by western standards, still handle payments by sending each other paper checks in the mail?

TAGS: Economics Farrokh Langdana Finance and Economics Macroeconomics Thought Leadership