Thursday, January 21, 2010
Here's an update to my post last month, showing China's GDP growth returning to double digits as expected. This is very impressive, and surely qualifies as one of the most impressive V-shaped recoveries to date. Yet the market is concerned that measures imposed by the government to curb bank lending, announced today, coupled with a rise in the required reserve ratio for banks last week, will threaten China's economic future. I see these measures instead as moves in the right direction.
Because China's currency is linked to the dollar, and the dollar is historically very weak and the Fed is promising zero interest rates for a long time to come, it is in China's best interests to resist the inflationary pressures that flow from a weak currency. Tighter monetary policy is one way to do this, but ultimately China will probably have to revalue the yuan against the dollar—unless the dollar rises appreciably in the interim. But neither a revaluation of the yuan nor a tightening of monetary policy should pose a threat to China's growth, because they would amount to appropriate measures to limit inflationary pressures. It's never a bad thing to do the right thing.
It's useful to recall the unwritten law of central banking. A central bank can successfully implement monetary policy by choosing one of three policy tools: controlling the exchange rate, controlling the money supply, or controlling an interest rate. Often central banks that choose the first option become tempted to use one or two of the other tools at the same time. We saw this in the years leading up to the S.E. Asian currency crises of 1997, when central banks raised interest rates to cool off their economies (at the IMF's suggestion, I might add) while also keeping their currencies pegged to the dollar. This can work for short periods, but it inevitably results in undesirable or unforseen consequences. The problem is that it is just about impossible for any human to use two policy tools to hit one policy target; the complexity is just too great. If policymakers can stick to just one tool, then markets and the economy can adjust given time.
Think about it: if China says the yuan will be fixed to the dollar, but then it raises its interest rates above dollar interest rates, this has the effect of attracting capital that would otherwise go to the U.S. Increased capital flows have to be purchased by the central bank in order to keep the exchange rate stable, but this increases the money supply and that, in turn, can put downward pressure on interest rates and/or result in an "overheated" economy. In short, the combination of these policies can end up in undesirable cross-currents.
So China is probably making a mistake by tightening monetary policy instead of just revaluing the yuan. But it could take a long time for this mistake to generate serious imbalances in the economy. In the meantime, investors know that China has a virtual mountain of reserves with which to back up its currency. That means the Chinese yuan is NOT going to lose its value; it can only remain steady versus the dollar or rise. So on the margin, the central bank's tinkering with monetary policy only increases the appeal of investing in China, since it means higher interest rates (which is equivalent to curbing bank lending) and/or an increased likelihood of further yuan appreciation against the dollar. And the more money that is attracted to China, the more resources it will have at its disposal to continue growing. For now, it's a virtuous circle.
Full disclosure: I am long CHN at the time of this writing.
Posted by Scott Grannis at 3:27 PM