Tuesday, January 12, 2010

China looks good

China's central bank today announced it was raising its required reserve ratio from 15.5% to 16.0%. Is this a reason to fear that the Chinese boom may turn into a bust? Hardly.

China's monetary policy is largely determined by the Federal Reserve, because China pegs its currency to the U.S. dollar. However, the Chinese have been reluctant to be completely at the mercy of Bernanke and Greenspan's whims. As the next chart shows, they allowed the yuan to appreciate against the dollar from 2005 through 2008, largely in response to the fact that the dollar became seriously weak over that same period. Why stay pegged to a collapsing currency? Better to float the yuan higher.

Allowing the yuan to appreciate was equivalent to a tightening monetary policy that in effect helped counteract the extremely easy monetary policy coming from the Fed during that period. To complement this tightening the Chinese central bank also raised its required reserve ratio from 6.0% in 2003 to 17.5% in mid-2008. The Chinese, like the Australians, are proactively tightening monetary policy, and the Fed should be following their example. This is not bad news for China, it is good news. Sound monetary policy is an essential ingredient to strong growth. And to judge from the top chart, China is back on track to more double-digit growth.


Bill said...


Do you agree that as our Fed raises interest rates, people will pull their money out of the stock market and put it in less risky assets? Are the zero interest rates as much as an explanation for the stock market rally as anything else?

Scott Grannis said...

I don't see higher interest rates posing a threat to risky assets for a long time. I think higher rates from the Fed would a) encourage people to see what is happening in the economy as a sign of healthy growth, and b) restore some confidence in the dollar (i.e., it would show that the Fed is not going to keep rates low forever and trash the dollar in the process). Besides, how could 2 or 3 or even 4% rates be a problem to an economy that is growing, with 2-3% inflation?

Zero interest rates are not driving this rally in equities. This is all about the return of growth fundamentals.

septizoniom said...

how do you know zero interest rates are not drving the rally in equities (and all other financial assets)?

chaim said...


What do you think of Contrarian Investor James S. Chanos' "warning that China’s hyperstimulated economy is headed for a crash, rather than the sustained boom that most economists predict. Its surging real estate sector, buoyed by a flood of speculative capital, looks like “Dubai times 1,000 — or worse.”

"He even suspects that Beijing is cooking its books, faking, among other things, its eye-popping growth rates of more than 8 percent."....


Scott Grannis said...

chai: I've read Chanos, and I've read other reports of impending doom in China. I've also read lots of things from people I respect and who have years of experience in China. I'm willing to overlook the bad things that Chanos and others point out, because there are so many other good things that the doomsayers are apparently ignoring.

Daniel said...

China is now what the US was in the 70's. The next 30 years will be just the beginning.

狂猪 said...

I know I've asked this before. However, I really have doubts that China's monetary policy is determined by the US Federal reserve.

China tightly control it's money supply by directly setting bank lending quota. This is particularly interesting and very different from the west. US and other developed countries influence credit demand by setting short term interest rate. Whereas, China directly manipulate credit supply by setting bank lending quotas. Since China's banking system isn't open, all banks operating in China have to follow the lending quota set by the government.

I wonder what the pros and cons of controlling money supply with the 2 approach:
- influence credit demand by setting short term interest rates
- directly manipulate credit supply by setting bank lending quota

At any rate, is it fair to say that a country that peg its currency to another do not have control over it's monetary policy only if it's banking system is open? Notice the Hong Kong dollar is peg to the US dollar and Hong Kong definitely doesn't have control over it's own monetary policy. China, with it's RMB, I think does have a lot control.

Scott Grannis said...

There are essentially only three ways that a central bank can implement monetary policy:

1) target the amount of money (which was what Volcker did in the late 1970s)

2) target an interest rate (which is what almost all central banks have done for decades)

3) target the exchange rate (which is mostly what China does, and is exactly what countries like Hong Kong and Bermuda have done for decades)

While it is possible to do more than one of these at the same time, such a practice is highly likely to result in unintended consequences. China is somewhat of a special case, however, since while they target the dollar exchange rate rigidly for many years at a time, they have also made periodic and significant adjustments (revaluations) to the rate. It thus becomes more difficult to analyze and characterize what the PBOC is doing.

The point of my post was to acknowledge that the PBOC is not pursuing a rigid policy and that it has made some important and needed changes and adjustments over the years. Thus, it is not clear at all that the Chinese economy has been led down a one-way street to disaster.