GOLDILOCKS AND THE CHINA BEARS / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( A MUST READ )

REVIEW & OUTLOOK

NOVEMBER 17, 2010.

Goldilocks and the China Bears


Rising inflation exposes the Achilles' heel of the Chinese growth model

Rising inflation threatens China's goldilocks economy. That may sound like hyperbole, given that the country's consumer price index remains quiescent by most standards. Last week, the October figures showed prices rising at 4.4% year on year, up from 3.6% in September. This is particularly painful for China's poor, and so officials need to contain it right away to preserve social stability.

But in a world in which many countries are worried more about recession and deflation than overheating, it may not seem like a big problem. Can't a bit of monetary tightening do the trick? Perhaps not this time. On monetary matters, China is an unusual case.


For the last seven years or so, it has enjoyed a phenomenal economic run. Not only has China's growth since 2003 been fast, it has also been less volatile than in the 1990s or early 2000s and inflation has remained at bay. While there were times when the economy slowed or overheated a bit, it always recovered. Beijing won kudos for its technocratic management.


How did the cadres do it? They deferred inflation by buying dollars and then sterilizing the increase in the supply of yuan. The proof is in the monetary policy reports of the central bank. Over the last seven years, the required reserve ratio has risen to a staggering 18% for large banks and 17.5% for other banks, up from 6% in 2003. The People's Bank of China has also been mopping up liquidity in other ways. For instance, as of the end of June, it had 4.4 trillion yuan ($665 billion) in central bank bills outstanding.


The U.S. Federal Reserve is under fire for expanding its balance sheet, but the PBoC puts it to shame. By holding down the value of the yuan while also limiting the money supply, China's central bank has enabled impressive export-dependent growth. And when the world economy stumbled, the government doubled down on investment, encouraging banks to lend freely for infrastructure. Now the bills are coming due.


In the near term, tightening credit could expose the weaknesses in China's corporations and put the banks under strain.


For a start, there's the question of how much more monetary policy ammunition the PBoC has left to fight inflation. A high savings rate has helped keep the banks liquid. Hot money will continue to come in, especially now that the Fed's QE2 has been announced, and the trade surplus for October was $27 billion. To keep the yuan-dollar exchange rate stable, the central bank has to continue sterilizing those money inflows before it can even start to fight inflation. If it is unable to do so, inflation could accelerate.


Then there's the PBoC's own financial health. Raising the reserve ratio has been its preferred method of controlling the money supply, since it doesn't have to pay interest on the funds commercial banks are forced to keep on deposit at the central bank.


But on its central bank bills and repos, it is borrowing at short-term rates of about 1.5% to 2%. On the asset side of its balance sheet it is earning less than 1.5% on five-year U.S. Treasurys. If the Fed succeeds in pushing down U.S. borrowing costs further, and inflation in China forces more interest rate increases, the spread on $2 trillion of foreign reserves is going to become costly. Not to mention that the yuan is appreciating against the dollar.


Unwinding even a portion of China's huge currency intervention would be painful. As economist John Greenwood of Invesco has written, the Malaysians engaged in a similar monetary strategy until the mid-1990s, when inflation emerged. After the central bank started making losses, it stopped sterilizing. All that deferred inflation came back in a rush. After the bubble burst, the oversized export side of the economy went into a tailspin, companies couldn't pay back their loans and a painful recession ensued.


In the near term, tightening credit could also expose the weaknesses in China's corporations and put the banks under strain. As long as the lending spree keeps going, companies appear healthy, banks' margins are fat and nonperforming loan ratios are low. The PBoC recently raised borrowing rates by 25 basis points, and the markets expect another rise before the end of the year. Lending quotas, China's main tool for controlling credit growth, could also be cut. For many companies, this could come as a rude shock.


For a long time, the question put to China bears has been what would spark a crisis. Capital controls mean that there is little possibility of capital flight, and the government stands behind the state-run banks so there seems to be no systemic risk. While we wouldn't be so bold as to predict a crash, inflation is one way in which China's goldilocks economy could come to an end and the bears be proven right.


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