China: The problem is easy credit, not easy money

China: The problem is easy credit, not easy money

Tyler Cowen linked to this interesting NYT story:

HONG KONG — Move over, Janet Yellen and Ben Bernanke. Step aside, Mario Draghi and Haruhiko Kuroda. When it comes to monetary stimulas, Zhou Xiaochuan, the longtime governor of the People’s Bank of China, has no rivals.The latest data released by China on Wednesday shows that the country’s rapid growth in money supply has continued. Mr. Zhou and his colleagues at the Chinese central bank have only begun the difficult and dangerous task of reining it in.

The amount of money sloshing around China’s economy, according to a broad measure that is closely watched here, has now tripled since the end of 2006. China’s tidal wave of money has powered the economy to new heights but it has also helped drive asset prices through the roof. Housing prices have soared, feeding fears of a bubble while leaving many ordinary Chinese feeling poor and left out.

.   .   .

This means the money supply is still charging well ahead of inflation-adjusted economic growth, which has been about 7.6 percent; the exact figure for the fourth quarter of last year is scheduled for release on Monday.

Growth in M2 almost reached 30 percent at the end of 2009, when China was using monetary policy to offset the effects of the global financial crisis. China has reduced the pace of money supply growth since then, but kept it well above the pace of economic growth throughout, which means it has done little to sop up the extra cash issued during the crisis.

The question now is whether the central bank can further slow the growth of credit and the money supply without causing a slump in housing prices or a sharp slowdown in the credit-dependent corporate sector. Even the very modest slowdown in money supply growth so far has already contributed to two sharp but short-lived increases in interbank interest rates in June and December, which roiled markets in China and around the world.

China’s central bank “is in a very difficult situation; it needs to tighten but the whole system is not used to tightening, they are used to money printing,” said Shen Jianguang, a China monetary economist in the Hong Kong office of Mizuho Securities, a Japanese investment bank.

M2 encompasses money in circulation, checking accounts, savings accounts and certificates of deposit. It is the main money supply indicator watched by the People’s Bank of China in trying to balance the need for economic growth with the dangers of inflation.

M2 has grown so fast in China not just because the central bank has been issuing a lot of renminbi but also because the state-owned banking system has lent and relent those renminbi with encouragement from the government, creating a multiplier effect.

China has also undergone a financial liberalization in the past five years that has accelerated the pace of lending. An extensive and loosely regulated shadow banking system has emerged, partly because of the willingness of regulators to allow banks to classify loans to new financing companies not as corporate loans but as interbank loans, for which little capital needs to be reserved.

.   .   .

Consumer inflation has not yet become a big problem in China: Falling commodity prices and widespread manufacturing overcapacity held down consumer inflation to 2.6 percent last year.

This is what happens when a journalist confuses money and credit.  Monetary policy is not especially easy by Chinese standards.  Yes, NGDP growth is running around 10%, but that number is down from previous decades.  Even if the number is too high (and it probably is) it’s changes in the rate of NGDP growth that really matter.  A NGDP growth rate that is gradually slowing year by year does not causes rapid RGDP growth in China.  It’s productivity growth that explains the China boom.

Now when we turn to the broad M2 “money supply” we are actually looking at credit, not money. This is a completely different issue.  I’d expect credit to grow faster than money in a developing country like China, but even so, I think it quite likely that credit growth (and hence M2 growth) is too rapid. The moral hazard problem in China is an order of magnitude worse than in the US.  This means there is a lot of misallocation of resources by the big banks.  Too much housing and infrastructure construction in secondary cities, for instance.

But the solution is not “tight money,” which would simply cause another sort of misallocation of resources.  Instead of too much construction you’d get too much leisure time, aka unemployment. The solution is a tighter credit policy, not tight money, which is of course politically difficult to do under the Chinese economic regime.  This is why they need to reform the banking system by making it less bad.  Adopting the horrible US banking system would be a huge improvement for China.  The Canadian system would be far better.

For the moment they’ll stick with their current system and continue to misallocate resources.  At some point there may be a tipping point and they’ll get a little bit of stagflation if they are lucky, or mass unemployment if the follow the BOJ/Fed/ECB playbook.  Let’s hope they keep NGDP growth stable and opt for stagflation.  Or better yet market reforms.

PS.  I have a post offering half-hearted praise to Keynesians, over at Econlog.