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January 09, 2010

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Great post, FWIW. I don't have a lot of immediate thoughts beyond the following:

a) Is a +20% revaluation enough to have kept a lid on that?

b) Is this really sustainable? "High powered money" growth has stagnated, I presume, because export growth has done likewise. That wouldn't be a problem if the Party has no interest in ramping up that engine again, but then they're back to having a lot of people with rising expectations but no way to hook into the system (with the previous method of choice having been migration to the coast or one of the inland manufacturing cities, and an exort mfg job.)

I think that Delong assumes that banks could borrow against the assets they hold against the central bank. I doubt that's true in the People's Republic.

About the revaluation: Imports averaged 31.2% of GDP between July of '06 and Sept. of '08, and the renminbi rose at an annual rate of 7.2%. So that gives you 2.2% off inflation right there, assuming full pass-through.

High-powered money grew at a CAGR of 32%. That's high! But real GDP grew at a CAGR of 11%. Inflation ran about 5%. So that's 11% + 5% + 2% = 19%. It leaves a residual, but considering that (a) that the Chinese government was leaning on its banks to be restrained, (b) the reduction in import prices has big effects, since they are inputs to all sorts of other stuff, and (c) this relationship isn't really stable, I'm not shocked that inflation wasn't higher.

Plus, what matters from the point of view of external sustainability is inflation that affects the Chinese cost of production --- since most imports to China are used as inputs to export stuff and not consumed locally, the effect on tradable price inflation is going to be much larger than the effect on inflation.

Make sense?

I don't see that much of a mystery. The primary way in which the Chinese government controls the economy is through reserve requirements, in which the banks are forced to take a huge amount of their wealth, and keep it in the form of government bonds. The "other liabilities" that you see on the PBC balance sheet consists of bonds issued by the PBC which it forces the banks to hold in as part of it's required reserves.

Forcing banks to hold required reserves has two major goods point in that:

1) it makes the banks more resistant to shocks. If you have a massive drop in real estate prices, then you have the reserves to prevent a liquidity crisis while you figure out a way of recapitalizing the banks.

2) it gets you out of the liquidity trap. One reason that the Chinese economy bounced back very quickly from the recession, is that the PBC pushed down reserve requirements allowing banks to pump massive amounts of cash into the Chinese economy.

All of this requires a huge savings rate. If you don't have savings then you can't have the banks hold large amounts of reserves.

Quote: At some point, the PBOC will no longer be able to keep up this balancing act.

I'd be curious to know why not.

Quote: In theory, I think, it should be sustainable as long as Chinese firms remain profitable enough to finance themselves via retained earnings despite the fact that a big chunk of those earnings wind up metaphorically sitting in the PBOC coffers.

And I don't see why this can't continue for another generation. PRC companies have no shortage of capital which they use to build factories which increases productivity which creates more money that gets put into the bank. As long as productivity can be increased by capital expenditure, there isn't anything that keeps things from growing.

All this will end when you have enough urbanization and capital investment at it's that point that you might see either a Soviet or Japanese crisis, but that's at least 20 years in the future. The other thing that will cause disruption is when you have retirees pull money out of the banks, but by that time, you have enough profitable factories so this is possible,

Actually, the "bond issue" wedge represents the bonds issued by the PBOC which the banks have to hold. The other liabilities are mysterious, although they have the same effect.

Never predict, especially about the future. That said, it is very hard to imagine the PBOC being able to continue sterilizing such large-scale capital inflows for a generation. Margins in many Chinese industries are already wafer-thin; if they drop much further, then Chinese firms will need more outside credit to finance growth.

And that's the rub. As long as China is running a massive trade surplus, the PBOC will be hard put to allow the banking system to provide that credit without sparking inflation.

That is another way of saying that fast productivity growth makes the PBOC's job much easier. Once that growth starts to slow, the options will close to (1) deprive the economy of credit; (2) appreciate; or (3) allow inflation to accelerate.

Productivity might continue to grow at 10% per year for 30 years, but that's not how I'd bet.

(Best pizza in NYC, by the way, is Patsy's at 117th and First.)

Just a comment on your text :
"In 2007 and 2008, things changed. High-powered money started to grow like gangbusters. So why didn’t inflation get out of control? Well, look at the red line: China let the value of the renminbi rise from roughly 12¢ per dollar to a bit over 14½¢. The rise in the renminbi helped keep a lid on import prices."

I believe this is part of the story. The other part, an important one, has to do with mandatory reserve requirements (RR). From mid 2006 to mid 2008, the PBoC progressively increased RR from 7,5% to 17,5%. In practical terms, it means that while overall bank reserves were increasing at a very fast pace during this period, banks were not able to increase their loan books at the same fast pace. The PBoC was effectively reducing the money multiplier during this period.

Very interesting. One point I just noticed is that according to the map showing visitors in the top left of your page, there have been no visitors from China.....

Hah! Perhaps it's censored? Somehow I doubt it, but you never know.

I believe this is part of the story. The other part, an important one, has to do with mandatory reserve requirements (RR). From mid 2006 to mid 2008, the PBoC progressively increased RR from 7,5% to 17,5%. In practical terms, it means that while overall bank reserves were increasing at a very fast pace during this period, banks were not able to increase their loan books at the same fast pace. The PBoC was effectively reducing the money multiplier during this period.

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