The flawed analogy of Chinese QE

03 May, 2015 - 00:05 0 Views
The flawed analogy  of Chinese QE The Peoples Bank of China

The Sunday Mail

The Peoples Bank of China

The Peoples Bank of China

WITH China’s central bank injecting cash in the financial system to support growth, commentators have been quick to dub it the start of Chinese-style quantitative easing. Analogies can be useful for explaining complex financial matters, but in this instance the comparison is more misleading than helpful. “QE” is a poor description of the way Chinese monetary policy works.

It also overstates the degree of easing the central bank is undertaking. Superficial parallels with the QE policies of America, Japan or Europe can be made.

Just as central banks in those countries have bought government bonds and other securities from lenders to expand the money supply, so is the People’s Bank of China looking to do something similar.

According to one report, it will acquire assets directly from commercial banks, just as the Federal Reserve did in buying mortgage-backed securities.

Another has likened it to Europe’s “long-term refinancing operations”, reporting that the central bank will lend directly to banks, taking local-government bonds as collateral.

There is no question that China is loosening monetary policy, and that it is doing so on multiple fronts. But the QE analogy falls down in two ways. First, the use of quantitative tools has long been the norm for China’s monetary policy. The government still sets a money-supply target every year (it is shooting for 12 percent M2 growth this year) and regulators rely on lending quotas to influence the behaviour of banks.

The central bank also adjusts the required reserve ratio, which determines how much cash is available to banks for lending, more often than it does interest rates.

The biggest unconventional gambit confirmed so far this year is “pledged supplementary lending” to the China Development Bank, whereby the central bank provides financing that it is then lent on for infrastructure spending.

This, however, is not a new policy. The Chinese central bank has regularly used similar forms of relending over the past two years.

As analysts at Westpac, an Australian bank, note, China has ratcheted up its easing in recent weeks but has not changed its style.

“China’s monetary policy is predominantly quantitative in nature, so yes, most initiatives it pursues under the current regime … will be more about quantum than price,” they write. The second problem with the QE comparison is that it exaggerates the extent of China’s monetary stimulus.

The loosening is intended in part to replace cash that has left China rather than to pump extra money into the economy. In the past the central bank relied on foreign-exchange inflows to generate money-supply growth (to simplify things a bit, it printed a steady stream of yuan to buy up the dollars entering the country from both trade and investment).

Capital flows have reversed over the past half year, however, leading the central bank to create base money through alternative channels.

China also has no need for QE.

The Bank of Japan and the European Central Bank, among others, have turned to quantitative easing because conventional monetary policies have run out of room.

Interest rates in these economies are close to zero and their central banks have had to come up with new ways to lower funding costs and spur banks to make loans. But in China, conventional policy still has plenty of space.

Benchmark one-year interest rates are above five percent and the required-reserve ratio is 18,5 percent, unusually high for any country. Why, then, does China bother with re-lending when across-the-board easing would be more effective in stimulating the financial sector? The answer lies in the question. Unlike central banks that have turned to unconventional tools for general easing when all else has failed, China uses its re-lending for targeted purposes, hoping to avoid splashing cash all over an economy when debt levels are already too high.

“The PBOC resorts to re-lending operations because it doesn’t trust financial markets to allocate credit to the areas that policymakers want it to go, not because it has concerns over banking sector liquidity,” say analysts at Capital Economics, a consultancy. If the central bank accepts local-government bonds as collateral, its objective will be to persuade banks to buy the bonds in the first place.

Yet this approach to monetary policy creates its own problems. For an economy that has grown as large and complex as China, quantitative tools are increasingly anachronistic. They can work when a financial system is largely closed. But as the capital account opens and bond markets displace banks, it is far more effective for central banks to focus on the price of credit (i.e., interest rates), rather than its volume.

Moreover, the attempt to target lending to deserving recipients speaks to the persistence of central-planning instincts. On the other hand, China has made plenty of progress over the past few years in freeing up its financial system and the central bank is, little by little, shifting to a price-based monetary policy.

Targeted lending, so long as limited in size, as it has been so far, helps to cushion an economy that is going through these structural changes. Easing has always been quantitative in China. The point is to get away from that. – The Economist

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