China’s two great walls of money

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In this column on March 13, I drew attention to a vast increase in the surfeit of deposits over loans in China’s banking system that built up in recent years. This great wall of cash – which all but doubled to Rmb9,300bn from the end of 2003 to the end of last year – is a result of China’s capital controls and households’ precautionary savings in a country with minimal welfare provision.

A liquidity glut is blocking government efforts to reform the financial system because banks are unable to price capital accurately when they are stuffed full of so much of it. All that happens, as recent data confirm, is that banks seek to lend out as much of their surplus deposits as government will allow, and at largely undifferentiated interest rates.

President Hu Jintao, touring the United States last week, signalled his surprise that China’s economy grew by an eye-watering 10.2 per cent in the first quarter. Yet a government that six months ago eased off on policy-based lending restrictions after a year of credit tightening should not be taken aback by what happens when it averts its attention from the financial system.

Aggressive lending, which drives much of China’s growth, is a structural given with so much excess liquidity and nowhere to park it but banks. Despite a recent modest pick-up, the Shanghai and Shenzhen stock markets have been in a six-year decline.

And so, in the first quarter, Chinese banks lent out Rmb1,260bn – half their targeted new lending for the year – which helped to drive a five percentage point leap in fixed investment growth to 28 per cent year-on-year, and nearer 33 per cent in urban areas.

The surfeit cash in the banking system, however, is only the first of two great walls of money that are constraining China’s room for policy manoeuvre – and bringing more speculators onto the scene. The second, which is also a function of capital controls and was very much to the fore during President Hu’s trip to the US, is the great wall of foreign exchange.

Numbers released during the visit show export growth is not tailing off, as many expected last year. Based on Chinese numbers, the trade surplus increased by around half, year-on-year, in the first quarter. This has led China’s foreign exchange reserves pass US$875bn by the end of March and suggests they will sail through US$1,000bn in the course of 2006.

The wall of foreign exchange is now indubitably a problem for the Chinese government, where once it was offered as a sign of economic virility. Inflows in excess of US$200bn a year can only be soaked up with looser monetary policy than the state would like, as the central bank prints renminbi to buy up dollars and euros.

The solution is a stronger Chinese currency, but here the government is discovering the perils of transitioning away from the artificial world of capital controls. As ever, Beijing seeks gradual reform. But this is a very tricky proposition because it promises to reward further foreign exchange inflows in an all-too predictable manner.

There was an initial 2.1 per cent appreciation of the renminbi against the dollar last July and a further 1.3 per cent since. The message this sends to the markets is that in a 12-month period Beijing’s planners will allow an aggregate appreciation of about four per cent. Sure enough, forward contracts on the renminbi that are traded in Hong Kong forecast that the Chinese currency’s exchange rate against the dollar will be four per cent higher in April 2007.

This is potentially a big problem for the Chinese government. So long as foreign exchange reserves and the US bilateral trade deficit continue to increase – the China Economic Quarterly expects the latter, by US data methodology, to increase to US$260bn or more this year – it is almost impossible to see the Chinese government backing away from steady renminbi appreciation.

When appreciation is a one-way bet, it can only suck in more speculative foreign capital. The stronger the inflows, the looser Chinese monetary policy will be and the greater the chance of an investment bubble.

The longevity and prognosis in this fearsomely strong Chinese cycle are no easier to estimate than previously. But the central roles of China’s two great walls of money are becoming clearer.

The China Economic Quarterly is an independent newsletter devoted to analysis of the Chinese economy and business environment since 1997. It draws on the 25 years of combined experience of its editors, veteran financial journalists Joe Studwell and Arthur Kroeber, and also publishes articles by leading China-focused economists and journalists. This column appears exclusively on FT.com on alternate Mondays.

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