Inºation and External Imbalances Facing China - Specialized Research AI at MIT

Inºation and External Imbalances Facing China
Inºation and External Imbalances Facing China

The New Challenges of Inflation and
External Imbalances Facing China*

Yongding Yu
Institute of World Economics
and Politics
No. 5 Jianguomenneidajia St.
100732
Beijing China
yuyongding@126.com

Abstract
China is facing the threat of inflation, at the same time that the
U.S. economy is in trouble. To maintain a sustainable growth rate,
China must walk a tightrope. On one hand, China must tighten its
monetary policy to bring inflation under control, which will slow
down the growth rate of the Chinese economy. On the other
hand, China also has to be ready to use expansionary fiscal policy
to replace the weakened external demand to prevent its econ-
omy from falling into a “growth recession,” where the growth rate
is below 8 percent, due to the double whammies of monetary
tightening and a significant slowdown of the U.S. economy.

1. Introduction

After ªve consecutive years of high growth since 2003, red
lights have suddenly started ºashing for the Chinese econ-
omy. China’s stock price has been soaring since the second
quarter of 2007, and the rise of property price has refused
to slow down. There is no doubt whatsoever that China’s
asset bubbles are serious. To make things worse, the con-
sumer price index has risen rapidly since July 2007. Eco-
nomic growth might be lowered unless policymakers can
reestablish control over both asset prices and inºation.1
Section 2 is devoted to the discussion of inºation. In this
section, the reason inºation should be treated as a serious
threat to China’s macroeconomic stability is discussed.
Section 3 analyzes excess liquidity, which is a major source
of China’s macroeconomic stability. Section 4 discusses the
Chinese government’s policy responses to asset bubbles

* The author is grateful to Cao Yongfu, who developed most of

the ªgures in the paper.

1 For a more comprehensive survey of the 10 most serious chal-

lenges facing China, the reader should consult Yu (2007).

Asian Economic Papers 7:2

Institute of Technology

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Inºation and External Imbalances Facing China

Figure 1. China’s economic growth (in percent, year over year)

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Source: CEIC.

and inºation. It concludes with a discussion of China’s policy responses to the chal-
lenges it is facing, and section 5 provides a summary of these important issues.

2. The threat of inºation to stability

Many observers feel that inºation is not the biggest threat to the stability of the
Chinese economy, despite the fact that consumer price inºation hit 6.5 percent year-
on-year in August 2007, which is the highest rate in 11 years and largely due to a
49 percent surge in meat and poultry prices. My point is that, “[it] is fair to say that
inºation is not an immediate threat to China’s economic stability. However, there
are many reasons for the Chinese government to worry about inºation.”2 The argu-
ments are as follows.

2 Yu Yongding’s comments, The FT Economists’ Forum, Posted by: Martin Wolf on 25 Oct 2007

12:53:51, available at http://www.typepad.com/t/trackback/676652/22518146

Asian Economic Papers

Inºation and External Imbalances Facing China

Figure 2. GDP growth and inºation (in percent, year over year)

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Source: Statistic Year Book, National Statistic Bureau, various issues.

First, China’s growth rate was more than 11 percent in 2007. According to consen-
sus, China’s potential growth rate was 8–9 percent. In China’s 11th 5-year program,
the growth target was set below 8 percent (Figure 1).

In the past, China has never been able to maintain a growth rate above 10 percent
for more than two consecutive years without causing serious inºation with a lag of
four to ªve quarters (Figure 2). In the current cycle, the Chinese economy has main-
tained a growth rate above 10 percent for 4 consecutive years, while keeping
inºation below 3 percent. This is already a miracle indeed. It should be not a sur-
prise that inºation has now begun to get worse.

Some observers have argued that China’s productivity has risen signiªcantly to in-
crease its potential growth to more than 10 percent. Therefore, they believe that
there is no excess demand and no danger of inºation. However, I do not believe this
claim. A large portion of the growth rate of 45 percent for ªxed asset investment was
caused by local governments undertaking city construction, and the GDP growth
has been characterized by wasteful use of energy and raw materials. It is therefore
hard for me to believe that China’s productivity (measured by total factor produc-
tivity or capital–output ratio) has improved so dramatically that China’s potential
growth rate has risen from 8 to 11 percent and that China will be able to maintain

Asian Economic Papers

Inºation and External Imbalances Facing China

Figure 3. China’s recent inºation (in percent, year over year)

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Source: CEIC, calculated by Cao Yongfu (Institute of World Economics and Politics).

the current growth momentum without causing serious inºation. I have no doubt
that there is excess demand in China and that excess demand is increasing.

Second, the recent food price hike (Figure 3) cannot be attributed entirely to external
shocks. The rise of consumer price index (CPI) is mainly due to the rise of food
prices, especially the price of pork. The core CPI is still quite low, below 2 percent.
Government ofªcials are quite conªdent that when piglets grow up next year, the
price of pork will go down and so will the CPI. Some economists disagree. It is not
just a matter of piglets. The rise of food prices is broadly based, and cannot be attrib-
uted to natural disasters, or isolated events. In fact, the prices of all inputs for food
production (ranging from seeds and fertilizer to pesticides) have risen, which
should be attributed in part to the demand-pull factors of the economy. For exam-
ple, real estate development has shrunk the size of China’s arable land rapidly,
pushing it to the lower boundary of preservation set by the government. Therefore,
the maturation of piglets will not lead to the fall of food prices across-the-board.
Though the government will be able to contain the rise of food prices for a while

Asian Economic Papers

Inºation and External Imbalances Facing China

through price controls, these factors are not temporary and will not go away auto-
matically.

Third, inºationary expectations have been established among the public. According
to a recent survey by the People’s Bank of China (PBOC), the public believes that
inºation will get worse. People have begun to withdraw their deposits to buy shares
and real estate, and push for higher increases in wages and salaries. Therefore, at
this stage, even if inºation is not a big threat to stability, worsening inºationary ex-
pectations are.

Fourth, the growth rate of wages and salaries has reached double digits in recent
years and continues to accelerate. This trend is not reºected in statistics, because un-
reported income (so called “gray income”) is large, and might be even larger than
formal income. Furthermore, the new labor laws and other regulations have pro-
vided a favorable legal environment for wage rises. Figure 4 shows the income
growth in urban and rural China.

Fifth, price distortion is still widespread. China’s energy price is among the lowest
in the world; taxes on mining and extraction activities are excessively low; pollution
is almost costless; and rents on lands in many places used for foreign direct invest-
ment (FDI) are inexpensive. The low inºation to a certain degree is achieved at the
expense of low efªciency and the misallocation of resources. Unless the government
gives up the plan for further price reforms, price increases for many important prod-
ucts are inevitable, which in turn may worsen inºationary expectations.

Sixth, China’s money supply has been growing at a much faster rate than that of
GDP for a long time. Currently, despite the PBOC’s intention of tightening broad
money (M2), M2 still grew more than 18 percent in August 2007. In other words,
China’s ªnancial conditions are still quite loose and conducive to inºation (see
Figure 5).

Seventh, since late 2006, China’s equity price has more than doubled and stock mar-
ket capitalization has increased from less than half of GDP in 2005 to more than
100 percent of GDP currently; see Figure 6. The wealth effect is ubiquitous. More
and more people who gained from the stock markets have started to spend lavishly
on luxury durable goods.

In short, all necessary conditions for the worsening of inºation are present in China.
So even if the inºation rate is still low, the government must be vigilant on inºation
and regard it as a big threat to stability.

Asian Economic Papers

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Inºation and External Imbalances Facing China

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

C
I
E
C

:
e
c
r
u
o
S

s
a
e
r
a
n
a
b
r
u
d
n
a

l
a
r
u
r
n
i

e
m
o
c
n
i

f
o
h
t
w
o
r
G

.
4

e
r
u
g
i
F

Asian Economic Papers

Inºation and External Imbalances Facing China

Figure 5. Growth of M2 and credits (in percent)

Source: CEIC.

Note: M2

broad money.

Figure 6. The rise of the equity price index

Source: CEIC.

Asian Economic Papers

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Inºation and External Imbalances Facing China

It is right to say that China’s growth of domestic demand remains subdued, rather
than overheated, relative to the rapid growth of potential and actual output. A large
portion of demand came from foreign markets. In 2006, the contribution of net ex-
ports to China’s growth was about 3–4 percentage points. Taking away the growth
contribution from trade, China’s domestic demand might not have been able to sup-
port a growth rate of 9 percent. If China fails to maintain export momentum, its
growth rate may fall signiªcantly, due to lack of demand. This implies that while
China is suffering overheating, the overheating could turn into deºation quickly.

China experienced investment fever from 2002 to 2004. As a result, in early 2005, the
economy showed signs of overcapacity. However, the expected slowdown of the
economy failed to materialize because of a second round of investment fever. In a
sense, China absorbed the overcapacity by creating more capacity. Unfortunately,
this practice is not sustainable. Overheating caused by over-investment at the cur-
rent period could be followed by deºation caused by overcapacity in the ensuing
period.

Inºation is a big threat to stability in two senses. First, it creates inºationary expecta-
tions, which in turn will sustain inºation by creating a vicious cycle of interaction
between cost-push and demand-pull factors. Second, inºation and asset bubbles
will reinforce each other and cause serious ªnancial instability. In my view, at this
moment, the most dangerous characteristic of China’s economic situation is the
symbiotic relationship between inºation and the asset bubble.

3. The sources of excess liquidity

In this paper, I deªne excess liquidity as excess money supply, which equals money
supply minus money demand. As I will argue later, before 2007 the main source of
excess liquidity came from the supply side of money. It came from the PBOC’s inter-
vention in the foreign exchange market to control the pace of the reminbi (RMB) re-
valuation in the face of increasingly large twin surpluses (current account surplus
and capital account surplus). To maintain price stability and contain asset bubbles,
the PBOC carried out a large-scale sterilization operation to mop up the excessive li-
quidity.3

Owing to the enormous scale of the sterilization operation, in just 3 years the PBOC
sold out all the government bonds it had accumulated since 1998 when the govern-

3 There are two major forms of sterilization. One is to sell government bonds and central bank

bills to commercial banks. The other is to raise the reserve requirements of commercial
banks.

Asian Economic Papers

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Inºation and External Imbalances Facing China

Figure 7. Amount of central bank bills outstanding (in RMB billion)

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Source: www.chinabond.com.cn Calculated by Zhang Ming.

Note: Our assumption is that the balance of central bank notes was zero at the end of 2002. The highest balance until now is RMB 4.3 tril-

lion in August 2007.

ment issued government bonds to stimulate an economy that was trapped in
deºation. The exhaustion of the bond-holding by the PBOC meant that there was no
more room for the central bank to manipulate the asset side of its balance sheet.
Therefore, the PBOC turned to the liability side in 2003, and began to issue central
bank bills to mop up the liquidity.

What is usually neglected in the analysis of sterilization is the impact of sterilization
on commercial banks. Because the supply of central bank bills is massive, the sale of
central bank bills should force up the interest rates in money markets, especially
when the economy is hot and the demand for credits high. However, owing to the
fear of speculative capital inºows that increase the pressure on the RMB to appreci-
ate, the PBOC had to somehow sell central bank bills without causing interest rates
in China’s money markets to rise too much, and, preferably, without causing interest
rates to rise above the London Inter-Bank Offer Rate (LIBOR).

The PBOC uses two types of auctions for central bank bills to soak up liquidity:
quantity auctions and price (yields) auctions. Quantity auctions are used most fre-
quently. They are aimed at selling a pre-announced amount of central bank bills and

Asian Economic Papers

Inºation and External Imbalances Facing China

Table 1. Reserve requirement ratios have been increasing steadily

Time of change: year (month/day)

Reserve requirement ratio (%)

2003 (09/21)
2004 (04/21)
2006 (07/05)
2006 (08/15)
2006 (11/15)
2007 (01/15)
2007 (02/25)
2007 (04/16)
2007 (05/15)
2007 (06/05)
2007 (08/15)
2007 (09/25)
2007 (10/15)
2007 (11/26)
2007 (12/25)

7.0
7.5
8.0
8.5
9.0
9.5
10.0
10.5
11.0
11.5
12.0
12.5
13.0
13.5
14.5

letting the market decide the price. However, often, when the PBOC felt the need for
further tightening, and knew that there would be difªculties selling the additional
central bank bills at the existing interest rates, it would select some commercial
banks and require them to purchase these bills, regardless of proªtability. (It is pos-
sible that the banks were sometimes selected on the basis of how enthusiastic they
were in extending loans in the recent period.) Because the commercial banks’ hold-
ing of central bank bills has been increasing more rapidly than bank loans and other
high-yield assets, the share of low-yield assets in banks’ total assets has been in-
creasing, which sooner or later would worsen the banks’ performance (see Figure 7).

Because most of the central bank bills are short-term bills of 3 months, the burden of
rolling-over for the central bank is tremendous. It becomes increasingly more
difªcult for the PBOC to sell exponentially larger central bank bills, unless increas-
ingly high yields are provided. It is very telling that there are many occasions in
auctions when the PBOC ªxed the price of central bank bills, and then failed to sell
all the bills, thus requiring the PBOC to designate certain banks to purchase the re-
mainder.

In addition to the sale of central bank bills, the PBOC has raised the required reserve
ratio 15 times between 1 September 2003 and 25 December 2007 (Table 1). The PBOC
raised the required reserve ratio from 6 percent to 7 percent on 1 September 2003,
and has then been raising it by half a percentage point periodically. At the end of
December 2007, the required reserve ratio had increased to 14.5 percent.

The key question is whether sterilization can be implemented indeªnitely. As long
as the interest rate paid by the central bank on its bills is lower than the correspond-
ing interest rate on American assets (say, the yields of Treasury bills), the central
bank should be able to sterilize indeªnitely, and therefore maintain effective control

Asian Economic Papers

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Inºation and External Imbalances Facing China

over the monetary base. However, there are several obstacles to the continuation of
large-scale sterilization.

First, other things being equal, the sale of central bank bills will push up the interest
rates in money markets, which in turn will invite more capital inºows and place
more upward pressure on the RMB, increasing the need for more sterilization. Un-
der certain circumstances, a vicious cycle will be created.

Second, when the overall ªnancial condition is tight, due to the existence of better
options, commercial banks may refuse to buy the low-yield central bank bills. As a
result, the yields of the central bank bills will be bid up and the central bank may
suffer from operation losses, especially if the Federal Reserve rate declines.

The large-scale sterilization through involuntary purchases of central bank bills at
low interest rates by commercial banks and the constant increase in the required re-
serve ratio has produced at least three serious deleterious consequences for the com-
mercial banks. First, the proªtability of the commercial banks has been reduced as
low-yield assets now account for more than 20 percent of their total assets.

Second, the attempt to maintain proªt margins has led commercial banks to increase
lending to riskier borrowers who pay higher interest rates. In fact, some banks are
providing loans to borrowers to speculate in equity markets without demanding ap-
propriate collateral. These sorts of activities create long-term damage to the fragile
banking system, which has been improving after recent injections of capital by the
PBOC and write-offs of nonperforming loans (NPLs).

Third, the forced purchases of central bank bills by commercial banks has compro-
mised the whole process of ªnancial reform.

Allsopp and Vines (2000, 7) have observed that in developed countries, “the most
important control instrument of the central bank is a short-term interest rate, which
inºuences the behavior of commercial banks by determining the price at which they
lend.” Interest rate policy is also an important instrument of monetary policy in
China. Since 1999 the interbank money market has assumed an increasingly impor-
tant role in inºuencing the liquidity and interest rate structure in the economy.
However, the so-called ripple effect of a change in benchmark interest rate is far
from perfect, despite the efforts of interest rate liberalization, due to the fragmenta-
tion of China’s money market. Furthermore, in China there is still no benchmark in-
terest rate equivalent to the Federal Reserve’s fund rate in the United States, the
bank rate in England, and the overnight call rate in Japan. Even though a few key

Asian Economic Papers

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Inºation and External Imbalances Facing China

Figure 8. Growth of monetary base (in percent, year over year)

Source: Wang Qing at Morgan Stanley.

short-term interbank interest rates are determined by market forces and can be
inºuenced by the PBOC, these rates cannot inºuence the whole interest rate struc-
ture of the economy automatically, or in a cascading way. More importantly, due to
the dual structure of China’s credit market: co-existence of large state-owned enter-
prises with abundant liquidity and small nonstate-owned enterprises without ade-
quate liquidity, the interest rate policy cannot be used to regulate the demand for
and supply of credits. In short, interest rate policy in China is not an effective tool to
inºuence the growth of money supply.

Although the sterilization policy has created serious problems for commercial
banks, which have to buy even larger amounts of low-yield central bank bills and
deposit an increasingly higher proportion of their cash with the central bank, steril-
ization operations are largely successful in mopping up liquidity. As a result, the
growth rates of monetary base and M2 have been broadly in line with the target of
the PBOC; see Figure 8 for details.

However, in my opinion, despite the relative success of sterilization, China’s ªnan-
cial system is still ºooded with excess liquidity. Otherwise, asset prices would not
have soared, the inºation rate would not have increased, and the growth rate of in-
vestment would not have remained high. Where does the excess liquidity come
from? The answer lies in the fact that excess liquidity is not only a money supply is-

Asian Economic Papers

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Inºation and External Imbalances Facing China

sue, but also a money demand issue. Under special circumstances, the fall in the de-
mand for money can be the cause behind excess liquidity.

My assessment is that the rise in asset prices and inºation before 2007 was certainly
attributable to excess liquidity created by the twin surpluses and capital inºows due
to expectations of RMB appreciation, and the central bank’s inability to sterilize
inºows sufªciently. However, the main culprit of the excess liquidity present in 2007
was due to a sharply weaker demand for money. Under these circumstances, even if
the PBOC had managed to totally sterilize inºows arising from China’s twin sur-
pluses and lower the growth of M0 and M2 to historical rates, money supply could
still have outpaced the demand and created excess liquidity.

There are two fundamental reasons behind the drastic decline in the demand for
money since 2007. First, the predilection to hold household savings deposits has
been weakening. Developments in capital markets have given normal savers the op-
portunity to diversify their assets. Stocks, bonds, and ªxed assets are now within the
reach of many. Along with foreign inºows, reforms in the stock market between
2004 and 2006 have played an important role in igniting the rise of stock prices. The
realization that higher returns can be obtained through the stock market has encour-
aged households to shift their deposits away from banks into stock exchanges. The
increase in share prices has in turn encouraged further ºight and asset price
inºation, ultimately creating a vicious cycle.

Second, even if citizens’ preference for savings deposits has not changed, interest
rate gains are being outpaced by price increases, hurting intentions to save in the
form of savings deposits. The worsening of inºation since the fourth quarter of 2006
has added fuel to the ªre. The rise in share prices and inºation accelerated the ºight
from household savings deposits to equity markets, which in turn make share prices
even higher.

Historically speaking China’s money supply growth rate has been far greater than
the GDP growth rate, and the pool of savings deposits is immense. China’s
M2/GDP ratio is more than 160 percent, perhaps the highest in the world. With
RMB 38 trillion deposits vis-à-vis a stock market capitalization of RMB 8 trillion, the
potential for deposits shifting away from banks and entering the stock exchange
market to drive up share prices is tremendous. Constant investment into equity and
real estate markets prevents rational valuation of assets; see Figure 9.

The current rise of share prices is a positive feedback process that is highly unstable,
and hence, the market can crash anytime. Decisive government intervention is re-

Asian Economic Papers

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Inºation and External Imbalances Facing China

Figure 9. Bank deposits and A-share market capitalization (in RMB trillion)

Source: CEIC.

quired to cool down the asset markets as soon as possible, but the government has
been reluctant or unable to do so because of many political constraints it is facing.

4. Policy responses to the threats to stability

The maintenance of price stability should always be the priority of the central
banks. Sharp rises in prices tend to erode the ability of prices to act as a signaling
mechanism for resource allocation. Another concern is that high inºation tends to
be followed by a rise in the Gini coefªcient. The low-income group is hurt the most
by inºation because this population does not possess ªxed assets as a form of
wealth preservation. Even if the poor participate in the stock market, the burden
of risk is immense. A widening of the wealth gap among different social groups
caused by inºation poses threats to social stability. Controlling inºation is not just
for the sake of economic stability, but as Keynes once noted, also a matter of social
justice.

The implicit target rate for China’s headline CPI is 3 percent but the current rate is
running at 6.5 percent. Most economists in China have tended to play down the im-
portance of current inºation until recently. Some economists had even argued for
creating inºation so that the real appreciation of the RMB could spare China the
trouble of nominal appreciation. Fortunately, in a recent meeting, Chinese authori-

Asian Economic Papers

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Inºation and External Imbalances Facing China

ties have decided the most important policy target is to prevent “structural price
rises from turning into serious inºation.”4

While continuing to raise reserve requirements and issue bills in open market opera-
tions, the central bank must also increase households’ desire to hold more money. In
other words, money demand needs to be raised. Paradoxically, the key to raising the
demand for money in the present time is for the PBOC to raise the nominal interest
rate5 even though the usual textbook exposition has the demand for money being a
negative function of the interest rate. There are two parts to the answer.

First, the monetary aggregate of concern is M2 not M0. The raising of the deposit
rate would encourage people to hold more M2 (more household saving deposits
and less cash, M0). Furthermore, the raising of the deposit rate to be above the
inºation rate would make holding M2 an attractive riskless investment compared to
holding equity or other real assets.

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

The second part of the answer is that the demand for money is also a negative func-
tion of the expected future inºation rate; that in the present time, a decisive hiking
of the nominal interest rate would lower the expected future inºation rate drasti-
cally, and hence increase the demand for money.

Balancing returns in different asset classes is the only way to strengthen demand for
money, easing the effects of disintermediation. However, the PBOC is inhibited by
its lack of freedom in setting rates because the higher interest rate would induce
greater capital inºows and create new liquidity from the supply side. In short, fun-
damentally, without capital controls, the high interest rate policy would be ineffec-
tive because the higher interest rate would attract more inºows that would, in turn,
lower the interest rate back to the original level. The logical solution, therefore, is to
strengthen capital controls or allow the RMB to be determined by the foreign ex-
change market. Unfortunately, China’s capital controls are leaky and authorities are
still reluctant to allow the RMB to revalue at a faster pace. China has to use all in-
struments, though none of them are effective.

It is worth noting that under China’s current circumstances, the collateral damage of
a big interest rate hike could be serious for commercial banks. This is because the
most important source of proªts to Chinese banks comes from interest spreads be-
tween the interest on loans and those on deposits, and asymmetrical rises in interest

4 From the Communiqué of the Conference of the Political Bureau of the Communist Party of

China, held on November 27th, 2007. Xinhua News Agency.

5 This was the way Premier Zhu Rongji cured inºation between 1994 and 1997.

Asian Economic Papers

Inºation and External Imbalances Facing China

rates in favor of household saving deposits (which are what I am suggesting) would
lower the banks’ proªtability. Even a symmetrical rise in the interest rates could
harm the banks because it would lead to an increase in household saving deposits
but a decrease in borrowing by enterprises.

Furthermore, the interest rate hike could cause a production cutback and decrease
the income of white-collar professionals who have mortgage loans. The possible de-
fault of these mortgage borrowers could cause serious problems for the banks.

However, a small increase in the interest rate is not very useful in raising the de-
mand for money. One possible alternative to raising interest rates deeply is to use
ªscal policy. For example, stamp duty is effective in containing equity bubbles.
However, the public response to the implementation of these kinds of policies can
be negative.

In the long run, the need to reallocate resources to accommodate economic growth
means that China must allow the RMB to appreciate. Current events prove that the
massive reserve accumulation is inºicting a welfare loss for the country. How long
must China underwrite America’s asset bubble? In the short term, RMB apprecia-
tion is appropriate for ªghting inºation. Over the past 3 years, RMB appreciation
has improved China’s terms of trade without reducing the trade surplus. China’s
ªscal strength is more than enough to ameliorate the possible damage to China’s ex-
port industry. The main threat to China’s exports is protectionism elsewhere. Slow
but steady appreciation has lengthened the adjustment phase for Chinese enter-
prises to adapt, depriving them of strong motivation to adapt in the process. At the
same time, it has provided speculators with an opportunity to enter China’s real es-
tate and ªnancial markets and enterprises. In fact, because of the slow appreciation,
a great amount of Chinese assets have already been purchased by foreign investors
at a discount. The negative effects of an unwillingness to move the currency should
not be underestimated.

China has tried countless methods to avoid RMB appreciation, for example, it has
sent government delegations abroad to make big purchases like jumbo jets, cut ex-
port tax rebates, encouraged domestic enterprises to invest overseas, opened up the
ªnancial services industry, and eased capital controls. These measures were neces-
sary but some of them have signiªcant negative side effects. Take the case of relax-
ing restrictions on capital outºows. Since 2003 the PBOC’s policy has been “easy
out, difªcult in.” The problem is that with widespread expectations about large
RMB appreciation, this policy is ineffective. The low use of the outward investment
mechanism (qualiªed domestic institutional investors, QDII) provides clear evi-
dence of a lack of demand for outºows.

Asian Economic Papers

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d

f
/

7
2
3
4
1
6
8
2
4
3
8
a
s
e
p
2
0
0
8
7
2
3
4
p
d

b
y
g
u
e
s
t

o
n
0
7
S
e
p
e
m
b
e
r
2
0
2
3

Inºation and External Imbalances Facing China

Relaxing capital controls on outºows to control domestic liquidity without making
the exchange rate regime more ºexible ªrst is putting the cart before the horse. Cap-
ital controls are China’s last defense and cannot be eased until China’s ªnancial re-
forms are complete. Growth is cyclical and a sudden change in China’s situation
could prompt massive capital ºight. If there were no restrictions on capital outºow
at that point, the effects on China’s economy would be disastrous. Capital account
liberalization should be treated as a segment of China’s structural reform and not a
stop-gap measure to solve China’s short-term imbalances.

5. Conclusion

China is facing the threat of inºation, and the U.S. economy is in trouble. The state
of the U.S. economy will have important consequences on China’s growth. To main-
tain sustainable growth, China must walk a tightrope. China must tighten its mone-
tary policy, but also be ready to use expansionary ªscal policy to replace the weak-
ened external demand to sustain its economic growth. Tight monetary policy means
that China has to continue its sterilization policy as well as raise interest rates. How-
ever, to implement a tight monetary policy, China should improve its management
of capital ºows and minimize the ºows aimed at arbitrage. Because China’s capital
control regime is quite leaky, carrying trade into China might become increasingly
attractive. As a result, China’s efforts at tightening monetary policy could be neu-
tralized. If capital control were to fail to stop capital inºows, then China might have
to allow a more speedy appreciation of the RMB so that the central bank’s burden
on sterilization would be reduced and monetary independence would be preserved
as well.

2008 will be a delicate year for China. However, because of China’s strong ªscal po-
sition, I am quite sure that whatever happens, China will be able to maintain sus-
tainable growth. There is no ground for pessimism.

References

Allsopp, C. J., and D. Vines. 2000. The Assessment: Macroeconomic Policy. Oxford Review of
Economic Policy 16 (4):7.

Yu, Yongding. 2007. Ten Major Issues of China’s Macro-economy. 21st Century’s World Economic
Report, 10 December 2007, Beijing: South China News Group, 37–39.

Asian Economic Papers

D
o
w
n
o
a
d
e
d

f
r
o
m
h

t
t

:
/
/

d
i
r
e
c
t
.

i
t
.

e
d
u
a
s
e
p
a
r
t
i
c
e
–
p
d