- Blog Post
- Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.
We know why the global economy grew strongly in the first quarter. Nothing changed. Or rather, the basic pattern that has driven global growth for the past few years intensified.
The US continued to be the engine of global demand growth. We don't have US import data for March, but the port data suggests that imports will bounce back, big time, from their blip down in February. Non-oil import growth is likely to be almost as impressive as the US oil import bill ... and that's saying something.
China continues to supply that demand. China exports are up close to 30% y/y. And China is now to investment what the US is to consumption. Fixed asset investment is up 30% y/y. China's investment boom also provides impetus for global demand - even if in aggregate, China still saves more than it invests.
It isn't hard to figure out why Chinese investment growth accelerated in q1. After several quarters of restraint, Chinese banks lent like mad in q1. With a guaranteed spread between deposits and loans, the banks have a strong incentive to grow their lending book. The equation is simpe: More lending = more current profits. Nore future risks too, but that doesn't seem to worry many bankers right now.
China's central bank had been holding back lending growth with administrative controls, leading deposits to pile up in the banking system. In the first quarter, the central bank either eased up or the banks stopped paying attention. Who knows. But if the PBoC did want to ease up to generate a bit more domestic demand, it now seems to worry that it may have unleashed a bit too much of a good thing.
Like Dr Roubini, I am not convinced a massive 27 bp increase in an economy growing -- in nominal terms -- at 15% will have any impact on lending growth. Even after their recent lending spree, the banks are very liquid, with lots more deposits than loans. That has put downward pressure on lending margins. I don't see that changing quickly. The central bank will need to continue to use administrative controls to limit lending growth.
UPDATE: Andrew Browne and Michael Phillips -- or at least the WSJ's headline writers -- play China's 27 bp rate increase as a signal of "movement toward market economy." They are drawing on quotes from Andrew Bernard of Dartmouth. I still have a rather different take. China's various baby steps (27bp here, a 2.1% revaluation there) strike me as too small to matter. And as a result, to me, they reflect continued resistance to letting key prices -- the price of money, the price of energy, the price of foreign exchange -- drive the allocation of economic activity. Some are struck me the fact that China has moved a bit, I remain far more struck by the fact that the moves are so small in the face of the economic forces now working through China that, in practical terms, they have next to no impact. And they force China to rely on other policy tools -- notably administrative guidance on credit -- to try to rein the economy in.
The Economist has noted that the IMF -- despite its best efforts -- will never be more than the "master of ceremonies" for the global economy. The Chinese will never let the IMF be the "master of currencies."
But what I don't really understand is why China believes that it continues to be in China's interest to resist currency appreciation.
China's central bank is clearly worried that China is investing too much. Rightly so. Investment is now close to 50% of China's (revised) GDP. And investment is rising relative to GDP. One obvious response is higher lending rates. That means something like what the Fed has done - not a token 27 bp increase. Particularly not when the central bank flooded the banking system with liquidity to keep a range of rates - rates on central bank bills and government bonds among others - down during the previous year. So long as China pegs to the dollar, its central bank's hands are tied.
Some argue that China's peg allows it to import US monetary policy. That is false. Right now China's monetary policy is far looser than US monetary policy. Fast reserve growth - even with lots of sterilization - is leading to rapid growth in base money. The Fed has tightened more than the PBoC. That is a conscious policy choice: to limit hot money flows, China wants to keep its deposit rates (and a host of other rates) below US rates. That means interest rates remain quite low - in my view too low - for an economy in the midst of an investment boom.
Another obvious response to concerns about an overheated economy - and an overheated export sector - is a stronger currency. Yet China won't let the RMB breach 8 (i.e. be worth more than 12.5 cents). And with the dollar now depreciating against a range of other currencies - and with inflation in China lower than inflation in the US - China's exchange rate is probably depreciating in real terms in the midst of its boom.
That also doesn't make sense to me.
Some say the exchange rate spurs job growth. Yet Asian job growth hasn't been that impressive. Low interest rates encourage the substitution of capital for labor.
Some say that China can not let its nominal exchange rate appreciate without replicating Japan's experience with a "bubble" economy.
I think that misreads the causes of Japan's bubble, which didn't stem from yen appreciation as much as from loose monetary policy in the face of yen appreciation ...
But it also seems to over generalize on the basis of one -- admittedly important -- example. Lots of countries have experienced currency appreciation without experiencing a bubble economy and then a decade of deflation. As Dr. Roubini notes, the yen appreciated from 73 on ... not just from 85 on. Germany's real appreciation in the 70s and 80s came in part from a nominal appreciation of the mark. And so on. More recently, the US dollar appreciated big time during the late 1990s investment boom.
China, though, seems so paralyzed by fears of being the next Japan than in practical terms, it continues to do very little. And as a result, its unbalanced economy keeps growing in an unbalanced way. Or perhaps Chinese policy has simply been captured by interests that benefit from a weak RMB. I don't know.
What I do know is that China keeps missing opportunites to let prices adjust, and instead adopts 1/2 measures that don't seem to work that well (I think Andy Xie is right on this point). China risks over-investing now, building too much capacity now, and then going through an extended period of subpar investment (and finding that it has built a lot of things it doesn't need). What goes up can come down.
In the end, China may get its own version of the bubble economy without an appreciating currency. Like Japan, the bubble would be spurred by a loose monetary policy. But in China's case, the loose policy would stem from efforts to avoid apprecation, not from efforts to keep growth up in the face of an appreciation.
In a paper presented to Chatham House's conference at New York on Monday, Karen Johnson - the director of the Federal Reserve Board's international staff - argued that excessive reserve growth can distort a whole host of markets, and a whole host of economic decisions (No link yet to the paper).
China's peg results not just in too much investment, but too much investment in China's traded goods sector. I don't take much comfort in the fact that HSBC thinks China's new rural development policy is, drumroll please .... , more exports.
China's peg also leads to too little investment in traded goods production elsewhere, including in the US. And too much investment in sectors that are insulated from Chinese competition - and that benefit from the financial flows associated with China's peg. Yes, I am talking about real estate.
But that is only one set of distortions.
Johnson also noted that the peg ended up distorting China's financial system, as the banks were forced to hold sterilization bills rather than learn how to lend at market rates.
Lots of bad loans have been moved off the books of China's state banks and to the books of the central bank and the asset management companies (AMCs), so it is a bit unfair to say that China's banks are as rotten as they have ever been. The AMCs are the really rotten ones now.
But that doesn't mean China's financial system is functioning well. So long the central bank relies on a host of non-market measures to try to keep everything from getting out of control when all the market incentives - lots of deposits, lots of loan demand, low interest rates - say "go," China's financial system will not learn how to allocate capital efficiently. Administrative controls are slapped on, loosened and then tightened again.
Johnson didn't argue that China's peg also distorts the US financial system.
But others have made that argument. I for one suspect financial flows from China - and from the Gulf - have contributed to low spreads and high valuations in certain US markets as well.
And the large profits of the financial sector no doubt pulls in talent that otherwise might be devoted to other professions. That too is a potential distortion. Physcis or high finance ..
The risk is that so many decisions have been taken in the expectation that these distortions will remain, and that betting on the continuation of the status quo will be continue to be rather profitable. Which makes any change not just difficult, but rather risky.
I am drifting away from my core point though. China shouldn't change its peg because the US says so, or because the IMF says so. It should do so because it is in China's interest to have a tighter monetary policy than the US has, not a looser monetary policy.
A country in the midst of a once in a generation investment boom shouldn't be holding its policy interest rates essentially still as the rest of the world tightens.
Its currency shouldn't be tied to a depreciating currency either. The RMB has moved by less than 1% against the dollar this year. The Euro is up almost 6% this year (using yesterday's euro/dollar close) ... So the RMB is falling once again against the euro and a whole of other currencies, despite China's balooning trade surplus and overheated economy.