One small point of disagreement with Martin Wolf on China

More often than not, I find myself agreeing with Martin Wolf.    His recent column summarizes what China should do far more succinctly than I ever coul

China, in short, needs better balanced growth: it needs higher consumption and less – and less wasteful – investment; it needs a slower rate of growth of exports and smaller current account surpluses; it needs a more flexible exchange rate and smaller foreign currency reserves; and it needs a much more efficient financial system.

That makes me feel somewhat guilty quibbling with one small point he raises.  He argues that China needs to be vigilant lest capital flowing into China create major balance sheet mismatches.

Intervening massively in the foreign currency market while capital flows inwards risks generating dangerously unmatched balance sheets in the financial system.

I take balance sheet mismatches quite seriously.  And big inflows from abroad often do lead to balance sheet mismatches.   That was the story of the Asian tigers in the 1990s, among others.

But I don’t worry much about foreign currency mismatches in China.  At least not in China’s private financial sector.   See my CESifo paper.

One thing about an obviously undervalued currency: folks want to hold it, in anticipation that  it will appreciate over time.   Chinese citizens generally have been shifting deposits from dollars to RMB.  That means less of a mismatch.    Foreigners generally want to invest in Chinese RMB too if they can.  That too means less of a mismatch.  The Chinese financial system basically operates in RMB, not in dollars.

Some banks were borrowing from abroad in dollars to lend in dollars to Chinese firms.  But the authorities clamped down on this.  And in any case, borrowing in dollars poses far fewer risks in the face of appreciation than a depreciation.  Borrowing in dollars if you have RMB revenues is a way of betting on appreciation.  Which is why the central bank stepped in – it didn’t like buying all the dollars from folks in China betting against the central bank.

There just isn’t much evidence of a balance sheet mismatch in China’s banks.  Apart from the one the PBoC itself created when it recapitalized three state banks with foreign currency reserves.

Best I can tell, the only institution in China that has a big balance sheet mismatch is the central bank.  And it has the mother of all fx mismatches.    But we all knew that.

There is another mismatch in the China.  There is an enormous gap between the RMB deposits the banks have taken in and the loans that they have been allowed to lend out.  The banks are effectively sitting on a huge pile of cash.   And that gives rise to all sorts of risks.  Loosen the controls that restrain lending just a bit, and the banks have every incentive (at least in the short-run) to lend out at a guaranteed 5-6% (China keeps a floor on lending rates) rather than buy PBoC bills at 2-3% … 

The gap between deposits and allowed lending is the big balance sheet mismatch in the financial sector, not any mismatch in foreign currency.

That is why I take Chinese arguments that any upward pressure on the currency would lead to the kind of problems Japan experienced after the yen appreciated in 1985 with a grain of salt.

First of all, the yen started to appreciate early in the 70s, and both the 70s and 80s were pretty good for Japan.

Second, I think that the bubble economy that burst had its roots not in yen appreciation per se, but also in the Bank of Japan’s policy of responding to the yen’s rise by printing money.  The BoJ wanted to offset the negative impact of the yen’s rise on growth.  And it did – for a time. 

China is determined not to be browbeaten by the US into too rapid RMB appreciation.  But in the process of trying to hold the RMB down, it has effectively pursued Japan’s late 80s policy of monetary expansion.

Look at the rate of deposit and M2 growth in China right now.  Both are running at close to 20%.   

Japan got its bubble economy trying to offset the impact of yen appreciation.  China may end up getting its own version of the bubble economy trying to prevent RMB appreciation ….  

Chin also may be generating a bubble of sorts in its export sector.  China exported a bit under $270b of goods in 2001.   By 2004, that total reached $600b.   A recent forecast put China’s 2007 exports at close $1200b.  I am not the source of that forecast, but it doesn’t take a genius to see where it comes from … just plot out current y/y export growth for 06 and have it slow a bit in 07.

That is one hell of an expansion.  Chinese exports have significant imported content.  But even so, China is becoming very, very exposed to the global economic cycle.   Remember, China's non-oil current account surplus is now just a bit under 15% of its GDP, according to the IMF, and that is presumably the lower bound for the “value-added” in China’s export sector.

China, an enormous continental sized country, has pursued a development path that has left it exposed to the global economy in a way that Japan – whose export sector was never as big relative to its domestic economy – never quite was.

I don't China is at risk of repeating Japan's mistakes.  It is at risk of making mistakes all of its own.

One caveat: I do not know as much as I would like about late 80s Japanese monetary policy.  Those who are should feel free to let me know if I have gotten anything really wrong.