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Monetary control and China's most recent macroeconomic cycle
MONETARY CONTROL AND CHINA’S MOST RECENT MACROECONOMIC CYCLE Barry Naughton ABSTRACT: The paPerreviews the periodleading upto the severe macroeconomicfluctuationsin China in 1993. It notes the very rapid growth of M2 in 1992, and traces this growth to a change in the relation between deposits and ioaos. The authorsuggests a set of indicatorswhich Chinese policymakerscould use to guide monetarypolicy. JELClassification#s: E5, P3.
July 1993 marks the beginning of the fourth episode of rnacr~~~orni~ austerity policy since the beginning of economic reform in 1979, and the end of the fourth cycle of rapid expansion as well. While this continues China’s long history of economic instability, there are also characteristics of the most recent fluctuation that reflect specifically on the financial system, and in particular on the nature of monetary control. Since the mid-1980s, the Chinese Monet system has operated under a system of double, or overlapping, controls. The traditional control system of binding credit quotas, disaggregated to local bank branches, has remained in place. At the same time, following the creation of the People’s Bank of China (PBC) as a central bank, the (state-owned) commercial banks were also required to maintain reserves at the central bank equal to a specified percentage of deposits. These fractional reserve requirements, along with central bank lending and the total volume of deposits commercial banks were able to attract, also set a limit to the volume of loans a commercial bank branch was able to lend. For any given bank, only one of these two systems could be binding at any one time. The bank could lend only if it both had the moneyaccording to the requirements of the fractional reserve system-and the credit quota that permitted it to lend. Since the last austerity program, implemented at the end of 1988, it had generally been the credit quotas that had been binding.
DEVELOPMENTS IN 1992 The commercial banks are required to keep reserves at the central bank equal to 13% of their deposits. But with strict credit quotas and a rapid increase in household saving, additional reserves beyond those required increased steadily after the end of 1988. By the end of 1991, commercial banks had additional reserves on deposit with the central bank, above and
Dhct all correspondence
to:
Bany Naughton,WPS, 0519, Universityof California,San Diego, La Jolla, CA
92093-os19. China Economic Review, Volume 4, Number2.1993, pages 231-234 All rights of repmductionin any form reserved.
Copyright0 1993 by JAI Press, Inc ISSN: 1043-951X.
232
CHINA ECONOMIC REVIEW
VOLUME 4(2)
1993
beyond their required reserves, equal to 12.7 percent of deposits. During 1992, excess reserves dropped ~~atic~ly: by the end of 1992 additions reserves at the central bank amounted to only 4.9 percent of deposits, and by the end of January 1993, only 4.5 percent, close to what is required for ordinary transactions purposes (Xie Ping, 1993, pp. 10-16). This large change in the relation between deposits and loans substantially increased the money multiplier, and mechanically “explains” why the money supply (M2) grew at the rapid rate of 3 1 percent during 1992. Why did this dramatic change take place? T~hni~ally, credit quotas remained in place during 1992. But in practice, early in 1992, Deng Xiaoping’s southern tour gave great impetus to stepped-up economic reform and accelerated growth. With China’s fledgling stock markets in Shanghai and Shenzhen-promoted success stories, the central government gave tacit approval to a wide variety of “experiments” with emerging capital markets. Given the booming economy, potential returns were high in a wide variety of ventures. Commercial banks withdrew surplus reserves from the central bank and invested them in a range of ventures while central government regulators looked the other way. These activities took place without being counted as part of the credit quotas. In practice, credit quotas ceased to bind, because banks were allowed to find ways to get around them. Excess reserves in the banking system were quickly drawn down, and actual credit extended grew rapidly. Banks provided money to non-bank financial insti~tions or corporations under their effective control; or they engaged in direct investment in real estate and construction, sometimes in the form of joint ventures with enterprises. The (legal) inter-bank lending market revived strongly, allowing banks to loan to other banks that were willing to circumvent credit controls. The rapid increase in lending and money supply created a surge of inflationary pressure and-since much of the money was diverted into speculation in land and capital markets--created China’s first “bubble economy.” Additions problems are associated with the current situation. The banks are making what are in fact loans that do not show up in the statistics as loans, making statistics inaccurate and monetary control much more difficult. Banks are making investments without clear provision for the risks involved. Finally, the situation is rife with opportunities for corruption. Speculation in urban land has been particularly lucrative in the past two years. In fact, chaos in the financial system is evident in n~erous respects. Fiscal agencies have been removing funds from the banks in order to speculate on property and other markets. Fiscal reserve funds on deposit with the banks plummeted 53 percent during 1993, while enterprises, awash with liquidity, increased their deposits by 39 percent. The item “other sources of funds” in the bank balance sheets-normally a modest positive number-shows up as minus 117.8 billion yuan at the end of 1992. This zeems to mean that a hundred billion yuan are missing from the banking system! (State Statistical Bureau, 1993, p. 35). The one good aspect of the current situation is that the banks have now made the transition back to a system in which credit is determined primarily by fnnd availability through the fractional reserve system. If the authorities can control the irregularities in the system, then real credit growth will automatically slow down as the commercial banks reach the limits of their available funds. It is essential both to reduce the growth rate of credit and money, and to restore order to the financial system. Thus, the austerity policy and takeover of the central bank announced by Zhu Rongji at the beginning of July 1993 are necessary and overdue. At the same time, it would be harmful and unnecessary to return to a system in which credit is determined primarily by credit quotas. The fractional reserve system is entirely capable of restraining the growth of credit, so long as a modicum of legality is restored to the banking
MONETARY
233
CONTROL
system. The big burst of credit associated with the transition to the fractional reserve system has already occurred-there is no point in trying to “get it back.” Instead, the fundamental task is to regularize and legalize the legitimate operations of the banks, while liquidating corrupt and excessively risky operations as quickly as possible. It is worth noting that China has suffered in the past not only from expansionary phases that were overly inflationary, but also from austerity programs that were implemented in too extreme and abrupt a fashion. That is an important danger to avoid during the current retrenchment.
LEADING
INDICATORS
FOR MONETARY
POLICYMAKERS
Finally, this discussion permits us to raise the issue of which indicators are appropriate to guide the determination of monetary policy in China. Past experience in this respect has not been encouraging. Rapid monetization of the Chinese economy has made it difficulty to rely on one or two indicators. When monetization began in the early 198Os, those who monitored the growth of monetary aggregates during the 1980s continually predicted that the economy would overheat, and the dire predictions repeatedly failed to come true. By the time the economy finally did overheat, advocates of conservative macro-policy had cried wolf one time too often: when the wolf finally came, nobody was paying attention anymore. By now, everyone accepts that the Chinese economy is undergoing a healthy process of monetization, but whether this process is stable, and how long it will continue, is unknown. Thus, while monitoring monetary aggregates should certainly be a cornerstone of monetary policy determination, it is likely that additional indicators should be monitored as well. The preceding discussion, however, indicates that statistics on the volume of credit extended are likely to be especially inaccurate, at least for the time being. Government policy-makers regularly monitor only one other source of information on macroeconomic conditions, and that is change in consumer prices. Here, however, the situation leaves much to be desired. In the first place, officials typically quote the retail sales price index as an appropriate measure of consumer price inflation. However, this is not a good measure since it overweights manufactured consumer goods, and undercounts food and services. Moreover, close monitoring of consumer prices suggests that policy-makers have been unduly influenced by the traumatic episode of panic-buying during 1988. In this, they resemble generals busy fighting the last war. The huge increase in consumer good availability over the past decade has in fact meant that this is one of the last areas in which inflationary pressures have been evident-yet that doesn’t mean that inflationary pressures are thereby any less significant. In general, we would expect inflationary symptoms to be evidenced first in asset markets. In the past, China didn’t really have any asset markets. Now, however, she does, and those markets provide sensitive indicators of inflationary pressures. This is potentially a great advantage to China, since she can rely on these sensitive early indicators of inflation to curb macroeconomic imbalances before they begin to affect the sensitive area of consumer prices. But this potential advantage can only become reality if there is a system of indicators in place that can signal back to policy-makers the need for changes in policy. The lack of such a system was a serious problem in 1992, and caused policy-makers to defer anti-inflationary measures far too long. What would such a system of indicators look like? It would be wise to borrow a page from the book of macro-planners in Taiwan. This would involve compiling a list of 8-12 macroeconomic indicators. For each of these indicators, a green (safe); yellow (warning);
234
CHINA ECONOMIC REVIEW
VOLUME 4(2) 1993
and red (danger) value can be determined in advance. If a single indicator is in the red zone while others are green and yellow, there will be no strong indication to policy-makers to tighten policy. However, as more and more indicators shift to the red zone, pressure on policy-makers will mount. This will be more effective the more widely publicized the system of indicators has been. The major components of this indicator system could consist of: I.
Growth of Monetary aggregates A. M2 (cash and demand deposits) B. Currency
C. Total credit (with better statistics) D. Non-bank credits, including inter-enterprise debts. II. Increase of Price Level. A. Consumer price index (not retail price index) B. Investment goods price index C. Raw materials and commodities price index. III. Asset market indicators. A. Free market exchange rate. B . Land prices. C. Free market gold prices. IV. Inventory levels. A. B. C.
Consumer goods inventories. Energy stockpiles. Construction materials stockpiles.
If such a system of indicators has been in place during 1992, it would have registered severe macroeconomic imbalances by mid-year. The last indicators to turn “red’ would almost certainly have been the consumer price index and consumer goods inventories. Several months before those indicators displayed serious imbalances, all the other indicators would have flashed red, signalling to policy-makers that it was time to shift policy, and strengtbening their resolve to do so. This would have enabled policy-makers to begin cooling down the economy at least six to nine months before they actually did, significantly reducing the costs of fighting inflation.
REFERENCES State Statistical Bureau. (1993). Zhongguo Tongji tiiyuo (Statistical Abstract of China). Beijing: Zhongguo To@. Xie, P. (1993). Three current problems of China’s monetary Policy. Guige, 3,10-16.
July 1993 marks the beginning of the fourth episode of rnacr~~~orni~ austerity policy since the beginning of economic reform in 1979, and the end of the fourth cycle of rapid expansion as well. While this continues China’s long history of economic instability, there are also characteristics of the most recent fluctuation that reflect specifically on the financial system, and in particular on the nature of monetary control. Since the mid-1980s, the Chinese Monet system has operated under a system of double, or overlapping, controls. The traditional control system of binding credit quotas, disaggregated to local bank branches, has remained in place. At the same time, following the creation of the People’s Bank of China (PBC) as a central bank, the (state-owned) commercial banks were also required to maintain reserves at the central bank equal to a specified percentage of deposits. These fractional reserve requirements, along with central bank lending and the total volume of deposits commercial banks were able to attract, also set a limit to the volume of loans a commercial bank branch was able to lend. For any given bank, only one of these two systems could be binding at any one time. The bank could lend only if it both had the moneyaccording to the requirements of the fractional reserve system-and the credit quota that permitted it to lend. Since the last austerity program, implemented at the end of 1988, it had generally been the credit quotas that had been binding.
DEVELOPMENTS IN 1992 The commercial banks are required to keep reserves at the central bank equal to 13% of their deposits. But with strict credit quotas and a rapid increase in household saving, additional reserves beyond those required increased steadily after the end of 1988. By the end of 1991, commercial banks had additional reserves on deposit with the central bank, above and
Dhct all correspondence
to:
Bany Naughton,WPS, 0519, Universityof California,San Diego, La Jolla, CA
92093-os19. China Economic Review, Volume 4, Number2.1993, pages 231-234 All rights of repmductionin any form reserved.
Copyright0 1993 by JAI Press, Inc ISSN: 1043-951X.
232
CHINA ECONOMIC REVIEW
VOLUME 4(2)
1993
beyond their required reserves, equal to 12.7 percent of deposits. During 1992, excess reserves dropped ~~atic~ly: by the end of 1992 additions reserves at the central bank amounted to only 4.9 percent of deposits, and by the end of January 1993, only 4.5 percent, close to what is required for ordinary transactions purposes (Xie Ping, 1993, pp. 10-16). This large change in the relation between deposits and loans substantially increased the money multiplier, and mechanically “explains” why the money supply (M2) grew at the rapid rate of 3 1 percent during 1992. Why did this dramatic change take place? T~hni~ally, credit quotas remained in place during 1992. But in practice, early in 1992, Deng Xiaoping’s southern tour gave great impetus to stepped-up economic reform and accelerated growth. With China’s fledgling stock markets in Shanghai and Shenzhen-promoted success stories, the central government gave tacit approval to a wide variety of “experiments” with emerging capital markets. Given the booming economy, potential returns were high in a wide variety of ventures. Commercial banks withdrew surplus reserves from the central bank and invested them in a range of ventures while central government regulators looked the other way. These activities took place without being counted as part of the credit quotas. In practice, credit quotas ceased to bind, because banks were allowed to find ways to get around them. Excess reserves in the banking system were quickly drawn down, and actual credit extended grew rapidly. Banks provided money to non-bank financial insti~tions or corporations under their effective control; or they engaged in direct investment in real estate and construction, sometimes in the form of joint ventures with enterprises. The (legal) inter-bank lending market revived strongly, allowing banks to loan to other banks that were willing to circumvent credit controls. The rapid increase in lending and money supply created a surge of inflationary pressure and-since much of the money was diverted into speculation in land and capital markets--created China’s first “bubble economy.” Additions problems are associated with the current situation. The banks are making what are in fact loans that do not show up in the statistics as loans, making statistics inaccurate and monetary control much more difficult. Banks are making investments without clear provision for the risks involved. Finally, the situation is rife with opportunities for corruption. Speculation in urban land has been particularly lucrative in the past two years. In fact, chaos in the financial system is evident in n~erous respects. Fiscal agencies have been removing funds from the banks in order to speculate on property and other markets. Fiscal reserve funds on deposit with the banks plummeted 53 percent during 1993, while enterprises, awash with liquidity, increased their deposits by 39 percent. The item “other sources of funds” in the bank balance sheets-normally a modest positive number-shows up as minus 117.8 billion yuan at the end of 1992. This zeems to mean that a hundred billion yuan are missing from the banking system! (State Statistical Bureau, 1993, p. 35). The one good aspect of the current situation is that the banks have now made the transition back to a system in which credit is determined primarily by fnnd availability through the fractional reserve system. If the authorities can control the irregularities in the system, then real credit growth will automatically slow down as the commercial banks reach the limits of their available funds. It is essential both to reduce the growth rate of credit and money, and to restore order to the financial system. Thus, the austerity policy and takeover of the central bank announced by Zhu Rongji at the beginning of July 1993 are necessary and overdue. At the same time, it would be harmful and unnecessary to return to a system in which credit is determined primarily by credit quotas. The fractional reserve system is entirely capable of restraining the growth of credit, so long as a modicum of legality is restored to the banking
MONETARY
233
CONTROL
system. The big burst of credit associated with the transition to the fractional reserve system has already occurred-there is no point in trying to “get it back.” Instead, the fundamental task is to regularize and legalize the legitimate operations of the banks, while liquidating corrupt and excessively risky operations as quickly as possible. It is worth noting that China has suffered in the past not only from expansionary phases that were overly inflationary, but also from austerity programs that were implemented in too extreme and abrupt a fashion. That is an important danger to avoid during the current retrenchment.
LEADING
INDICATORS
FOR MONETARY
POLICYMAKERS
Finally, this discussion permits us to raise the issue of which indicators are appropriate to guide the determination of monetary policy in China. Past experience in this respect has not been encouraging. Rapid monetization of the Chinese economy has made it difficulty to rely on one or two indicators. When monetization began in the early 198Os, those who monitored the growth of monetary aggregates during the 1980s continually predicted that the economy would overheat, and the dire predictions repeatedly failed to come true. By the time the economy finally did overheat, advocates of conservative macro-policy had cried wolf one time too often: when the wolf finally came, nobody was paying attention anymore. By now, everyone accepts that the Chinese economy is undergoing a healthy process of monetization, but whether this process is stable, and how long it will continue, is unknown. Thus, while monitoring monetary aggregates should certainly be a cornerstone of monetary policy determination, it is likely that additional indicators should be monitored as well. The preceding discussion, however, indicates that statistics on the volume of credit extended are likely to be especially inaccurate, at least for the time being. Government policy-makers regularly monitor only one other source of information on macroeconomic conditions, and that is change in consumer prices. Here, however, the situation leaves much to be desired. In the first place, officials typically quote the retail sales price index as an appropriate measure of consumer price inflation. However, this is not a good measure since it overweights manufactured consumer goods, and undercounts food and services. Moreover, close monitoring of consumer prices suggests that policy-makers have been unduly influenced by the traumatic episode of panic-buying during 1988. In this, they resemble generals busy fighting the last war. The huge increase in consumer good availability over the past decade has in fact meant that this is one of the last areas in which inflationary pressures have been evident-yet that doesn’t mean that inflationary pressures are thereby any less significant. In general, we would expect inflationary symptoms to be evidenced first in asset markets. In the past, China didn’t really have any asset markets. Now, however, she does, and those markets provide sensitive indicators of inflationary pressures. This is potentially a great advantage to China, since she can rely on these sensitive early indicators of inflation to curb macroeconomic imbalances before they begin to affect the sensitive area of consumer prices. But this potential advantage can only become reality if there is a system of indicators in place that can signal back to policy-makers the need for changes in policy. The lack of such a system was a serious problem in 1992, and caused policy-makers to defer anti-inflationary measures far too long. What would such a system of indicators look like? It would be wise to borrow a page from the book of macro-planners in Taiwan. This would involve compiling a list of 8-12 macroeconomic indicators. For each of these indicators, a green (safe); yellow (warning);
234
CHINA ECONOMIC REVIEW
VOLUME 4(2) 1993
and red (danger) value can be determined in advance. If a single indicator is in the red zone while others are green and yellow, there will be no strong indication to policy-makers to tighten policy. However, as more and more indicators shift to the red zone, pressure on policy-makers will mount. This will be more effective the more widely publicized the system of indicators has been. The major components of this indicator system could consist of: I.
Growth of Monetary aggregates A. M2 (cash and demand deposits) B. Currency
C. Total credit (with better statistics) D. Non-bank credits, including inter-enterprise debts. II. Increase of Price Level. A. Consumer price index (not retail price index) B. Investment goods price index C. Raw materials and commodities price index. III. Asset market indicators. A. Free market exchange rate. B . Land prices. C. Free market gold prices. IV. Inventory levels. A. B. C.
Consumer goods inventories. Energy stockpiles. Construction materials stockpiles.
If such a system of indicators has been in place during 1992, it would have registered severe macroeconomic imbalances by mid-year. The last indicators to turn “red’ would almost certainly have been the consumer price index and consumer goods inventories. Several months before those indicators displayed serious imbalances, all the other indicators would have flashed red, signalling to policy-makers that it was time to shift policy, and strengtbening their resolve to do so. This would have enabled policy-makers to begin cooling down the economy at least six to nine months before they actually did, significantly reducing the costs of fighting inflation.
REFERENCES State Statistical Bureau. (1993). Zhongguo Tongji tiiyuo (Statistical Abstract of China). Beijing: Zhongguo To@. Xie, P. (1993). Three current problems of China’s monetary Policy. Guige, 3,10-16.