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Finance & Economy

The myth about Chinese monetary policy


Government policies always generate conflicts of interests within society, monetary policy is no exception.

Foreign policies, to some extent, are the reflection and extension of domestic governance.

Domestic monetary policy, no matter how elusive and insignificant to some people, provides the currency for Chinese government’s outreaching tentacles around the world.

On October 7, 2018, the People’s Bank of China (PBOC) cut the reserve requirement ratio—the amount of money banks are required to hold at the central bank— for the fourth time this year, which unleashed about 1.2 trillion yuan ($175 billion) into the banking system.

This move signaled the Chinese government’s struggling to shore up its domestic economy amid the trade fight with the US. It also came after the PBOC’s injection of  149 billion rmb ($22 billion)  into the market in August, as an effort to encourage lending to companies and local governments. It seems that PBOC is on its way toward another monetary stimulus, but is this time different?

To understand what the PBOC or Chinese government’s policy agenda is, firstly it is necessary to grasp the essential policy tools of modern government to monitor and direct economic development. The US Federal Reserve uses policy tools such as open market operations, reserve requirements, discount rate, etc.,  in order to “promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy.”

Likewise, the PBOC considers maintaining the value of its currency and stimulating economic growth as its goals, with similar policy tools as its U.S. counterpart.

The major effect of these policy tools is the control of money supply in the market, which is usually done by central banks printing paper money. We’ve all heard that some central banks, take the Fed, are continuously printing more money and pumping them into the market.

It somehow creates a sense of being surrounded by prosperity and wealth. But, it has never been made clear how the newly printed money would affect the purchasing power of consumers, or put it in other words, the printed money decreases in its objective exchange value and therefore is definitely not identical with buying goods and services using this money.

In politics, the question is always about who gets power and when. When dealing with the political economy of monetary policy, it becomes essential to be aware of the distributional effects of monetary policy and observe where the money flows. A good start would be analyzing the so-called “expansionary monetary policy,” and its relation to inflation, which is also what these central banks barely disclose.

Why is your money depreciating all the time?

Nowadays in China, you would often hear people discussing and complaining that the cost of living has been eroding general standard of living continuously. This is clearly the case even though one’s income has been increasing. But as long as the pace of this increase in income falls behind that of the purchasing power of the monetary unit, people will still find their bank accounts shrinking.

Normally, people equate inflation with the rise in prices of goods and services. Governments, either in developed or developing world, have been trying to dismiss people’s fear of rising inflation, and obviously hyperinflation—the worst of its kind.

But, inflation is also an increase in the stock of paper money or increase in the money supply.  Facilitated by expansionary monetary policy, the demand for goods tend to increase because consumers now have more money to purchase, while the production of these goods are not being kept up with the pace of consumption, pushing up the prices of these goods and diminishing the purchasing power of the monetary unit.

Overall, the M2 in China, which is used to measure the broad money supply in market, has been increasing from 2008 to 2018 (Figure 1). Based on this rising trend, it now seems impossible to rein in PBOC’s fervor to increase money supply.

Figure. 1 The rising money supply in China

Source: Tradingeconomics.com | National Bureau of Statistics of China

The question remains: How is the money supply related to inflation? Many people still remember the huge stimulus package plan released by Chinese government right after the 2008 financial crisis, the inflation rate following this policy skyrocketed immediately ( Figure 2). From 2008 to 2018, the stock of money supply keeps increasing, with inflation going around 2% since 2012. So at least inflation fluctuates along the changes in money supply.

In 2018 from January to October on average, the consumer prices have risen by 2.1 percent from the same period from last year. The inflation rate has risen to 2.5% in October from around 1.8% in May ( Figure 3), which is followed by the increase in money supply when the trade conflict between US and China intensified,which further indicates that expansionary monetary policy tends to cause prices to go up.

Figure.2 Rapid increase in inflation following huge monetary stimulus plan

Source: Tradingeconomics.com | National Bureau of Statistics of China

Figure.3 Inflation rate rises after increase in money supply

Source: Tradingeconomics.com | National Bureau of Statistics of China

Apart from the technical details, what is more significant is the political function of monetary policy. Research has shown that inflation results in the transfer of wealth from wealth generators to the holders of the newly printed paper money. An increase of the quantity of money benefits the individuals who receive the new money units first because their monetary income increases relative to that of their fellow citizens. In China’s case, the question becomes who gets these newly printed money in the first place.

Where did all the money go?

With the support of expansionary monetary policy, banks are able to engage in adventurous lending activities. More significant in China’s case, these lending activities usually contain political motives. In China, state banks usually tend to favor state companies or certain sectors that are of crucial importance to the Chinese state.

Real estate is one major pillar of the Chinese economy; property developers are not only savvy entrepreneurs who know how to establish and maintain enduring relations with the government at all levels, they are also big recipients of bank credit. It is estimated that real estate accounts for about 30 percent of Chinese GDP. Therefore, it becomes obvious that monetary authority will pump its resources into the real estate sector and stimulate the economy.  

Whether it is done by lowering interest rates to encourage business investment in the real estate sector, or through easing bank lending to property developers and home buyers, the monetary authority creates a false signal in the market. Entrepreneurs expect bigger profits out of their investment in real estate, investors/home buyers wish that getting a piece of real estate promises larger gains in the future. The bare truth is that consumer demand for these real estate may not be up to the expectations of those property developers and policy makers, which is one of the reasons China has so many ghost cities where newly built while vacant apartment buildings abound. Thus, for both entrepreneurs and home buyers this is a decision of malinvestment; for the overall economy, a misallocation of resources.

A relevant factor for understanding the significance of real estate for Chinese economy is its relation to local government debt. To hedge against the risks posed to Chinese economy by the 2008 global financial crisis, the Chinese government launched a huge economic stimulus, which is an exemplar of China’s investment-led growth model. But the real lesson here is that by adopting this policy, the monetary authority is actually imposing invisible taxation on Chinese people through inflationary measures. Local governments used this borrowed money to finance infrastructure projects such as roads, bridges and industrial parks. Again, this artificially created wealth was distributed firstly into the pockets of contractors and businessmen who are well-connected to local government officials at the expense of ordinary taxpayers because they are forced to bear the cost of these public infrastructure projects.

When people wonder about the ascent of overseas Chinese companies, it is essential to point out that it is monetary policies that helped mould them into corporate leviathans.

Without doubt, in China, state-owned enterprises or some strategic industries, such as information technology, biotechnology and high-end equipment manufacturing, are also the beneficiaries of expansionary monetary policy. They are crucial because of their dual identities: economic agents and political agents who must fulfill the political agenda of the Chinese state.

Despite the fact that China now is the world’s second largest economy, it is still in a transition period, politically and economically. Under the socialist planned economy, state companies are the natural champions in receiving bank credit no matter how inefficient some of these companies were, which has casted a long shadow over the current and future Chinese society.

Globally, countries are already aware of the growing influence of Chinese companies, especially when they engage in a series of acquisitions and mergers in the fields of AI, energy and technology. Under the circumstances of China’s rise, it would be necessary for relevant stakeholders to monitor the direction of China’s monetary policy since it reflects not only general economic policies-making but also the political agenda of the state.

Is there a way out?

So, the key information regarding Chinese monetary policy is that it provides resources to the state in order to accomplish its political and economic goals, in most cases hidden behind the eyes of ordinary consumers. When one is confused and frustrated by the abstruse and complex technicalities of monetary policies, the general rule of thumb is to see where the money flows.

For average Chinese citizens, the most reasonable way to avoid financial troubles may be getting multiple sources of income because it may be too late before you realize that your money has been depreciated again. For Chinese private entrepreneurs and companies, the road ahead will still be rocky and full of uncertainties because the state and its monetary authority are the guardians of the national economy.

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About Yuxuan Liu

Yuxuan graduated from the University of Pittsburgh, with a Master's degree on Public and International Affairs and a major in International Political Economy. He has worked as a Policy Research Fellow at the Charles Koch Institute.

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