AAA  May. 5, 2015 7:30 PM ET
China facing tricky monetary task as it adjusts to current growth
  Matt O'Brien
The Washington Post News Service
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China has had 35 years of hypergrowth, but now it's over. The country is going to have to settle for really, really good growth instead.

But that's still going to be hard now that fewer Chinese are working age, fewer people are moving to the cities and, most of all, now that China has a debt bubble it's trying to deflate without bursting its whole economy. That has left the central bank, the People's Bank of China (PBOC), in the awkward position of trying to help the parts of the economy that need it without helping the rest too much.

Specifically, the PBOC will let banks loan out more of their money and give them cheap loans in return for local government debt. This sure looks like China is stepping on the monetary gas to try to keep its economic growth, which has slowed to a six-year low of 7 percent (if that), from slowing any further. But it's a little more complicated than that — as if monetary policy with Chinese characteristics wasn't already confusing enough.

Monetary policy is usually pretty simple. The central bank raises rates when it wants to cool the economy off and cuts rates when it wants to heat the economy up. But there are a couple more steps in China because of its dollar peg. Think about it like this: China not only wants to keep its currency, the renminbi, worth the same amount of dollars — albeit with a little wiggle room — it also wants to keep the renminbi worth the same amount of dollars after inflation. That's how it subsidizes its exports.

This last part is tricky, though. There were so many dollars coming into China, from trade and investment, that the PBOC had to print a lot of renminbi to keep the currency's value from going up. And that was a problem, since all that new money might have meant more inflation if it got out into the economy. So, to stop that from happening, the PBOC told banks that they couldn't lend as much money out — by raising their reserve requirement ratio (RRR). In other words, China printed money to prevent its currency from going up and then told banks they had to sit on that money to prevent inflation from going up.

But China isn't just trying to keep its currency at a level it wants. It's also trying to keep credit at a level it wants. That's why, as economist Mark Dow points out, the only way to tell whether China is tightening or loosening policy is to look at the total amount of loans being created. Sometimes there's so much money coming into the country that, even if China raises the RRR, it isn't really making money any tighter since the amount of credit is constant. But now, for the first time in a long time, the opposite is true. Enough money is leaving China that the nation has had to cut the RRR, which it's done more than expected, just to keep credit from falling.

It's worth thinking about this for a minute. When more money is leaving China than coming in, everything we talked about before goes into reverse. China isn't printing money to keep the renminbi down but rather spending its dollars to keep the renminbi up. And that means there isn't as much money to turn into loans — a passive monetary tightening — unless the PBOC says banks can lend more of what they do have.

China isn't cutting rates to try to make the economy grow more but instead to try to keep the economy growing as much as it already is. That might seem like just a word game, but it's not. China realizes that its economy is going to inevitably slow down, and it's not trying to fight that. It's just trying to keep it from happening all at once.

There's one last wrinkle. China not only tries to target the total amount of credit but also the kind of credit. That was easy enough when government officials could tell state-owned banks to lend and bully private ones into lending to whomever they wanted them to. But it's harder now that those banks have the freedom to say no to deals that don't look good, such as buying local government debt. Local governments borrowed so much over the past seven years that, because they rely on land sales for revenue, they could pay back what they owed only as long as property prices were rising. They're not now, though. In fact, housing prices are falling. It's gotten bad enough that local governments have started buying land from themselves to try to prop up prices and keep revenue coming in.

So the PBOC has tried to get banks interested by saying it will let them use local government bonds as collateral for cheap loans that they then have to relend to small businesses. The idea is to create demand for debt that nobody wants — but that needs to be rolled over — while nudging the banks to lend to whom officials want. In other words, the PBOC is subsidizing the banks that buy local government bonds by giving them all-but-guaranteed profits lending to small businesses. It's not so much monetary easing as monetary targeting.

If this strategy misses the mark, China's growth miracle isn't going to be much of one for much longer.

bc-china-econ-analysis (TPN)

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