Monetary Policy and the Future of China

by Dirk Ehnts

Michael Pettis had an interesting post recently on China. It is interesting because it highlights the way that China is affected by a liquidity trap. Let me elaborate on how monetary policy is supposed to work in an inflation-targeting regime in normal times.

A central bank reacts to inflation being either above or below a target by adjusting interest rates up or down. If there is low inflation, lower interest rates should stimulate investment – and maybe consumption, but let’s leave that discussion here for now for reasons that will become apparent later.Assuming the exchange rate is fixed, whatever happens to interest rates should not change net exports (doubtful in the long run, but anyway). Low demand is supposed to have led to low inflation, perhaps 1%. This signals to the central bank that demand has been falling and should be propped up. Therefore, the central bank lowers interest rates. Now, what?

The costs of capital decline, and investments becomes cheaper than before. Also, expectations change towards higher inflation in the future as people realize that with lower interest rates more people will start to invest. So, investment projects that are costly and demand a lot of capital increase in size and number, thereby increasing aggregate demand. The inflation rate comes back up, the problem is solved. The opposite occurs if rising demand causes inflation. However, something has not quite worked that way recently.

The main channel of increased investment spending is real estate. It’s costly and therefore the interest rate matters a lot, both for commercial and residential real estate. After a housing boom, with prices falling and expecting to fall further, will people go into debt to build new homes or modify existing ones? Will entrepreneurs build new offices, or expand existing ones? If the interest rate gets to zero and people still don’t start new projects, then we’ve hit the zero lower bound – the interest rate cannot be lower than zero (except for some pretty mind-boggling scenarios, which might be worth looking at, but not now and not here).

For the Chinese central bank, the People’s Bank of China (PBoC), a liquidity trap is a bit different. They can decide to build real estate no matter what happens, since the government has complete control over the PBoC. But won’t that lead to problems in the long run? Michael Pettis thinks so:

For this reason the idea that we can “grow” out of the debt problem once again by keeping investment high is wrong. First, it would only increase capital misallocation and debt levels, and would require even lower growth in the future. We can’t keep pushing the cost off into the future, as attractive an option as that always seems. Second it would put unbearable pressure on household income and consumption, and so ensure that the one thing China needs above all – a rapid rise in household consumption – is all but impossible.

When I was reading this for the first time, it all made sense to me. “Keeping investment high is wrong”, you’d just “keep pushing costs off into the future” and a “rise in household consumption… is all but impossible”. Financial crisis would seem to be coming to China. Except that although his reasoning might be right, there’s a different line of reasoning available. Before going down a different road, let me just comment quickly on the logic of Michael Pettis.

I agree that investment is very high in China, perhaps too high, but nobody can know for sure. The same thing applies to the efficiency of it all, but I would agree with Michael that the marginal efficiency of capital is probably decreasing. Regarding the consequences, however, I am not so sure. Let me develop a different scenario, where the economy moves along a road with persistently high (but not hyper!) inflation for a decade or so.

The financial problem for China from a balance sheet perspective is that some lenders cannot repay borrowers because their nominal income stream (either from profit or labor) is too low. This is because the efficiency of capital has not been what it should have been in order to fulfill all financial contracts. Now, there are two solutions to fix the balance sheet. One could allow for bankruptcy or renegotiation of debt until all (rewritten) contracts can be honored. A different idea is to “rewrite” financial contracts by increasing the rate of inflation. How would this work?

Let’s assume that the Chinese central bank (PBoC) decides to help debtors by increasing the money supply. At the same time, the government decides to let public sector wages increase. This is classic expansionary policy straight from your economics textbooks (IS/LM chapter, shift of LM and IS outwards). However, in the textbooks the understanding of Keynes is flawed. No inflation results because we are in a liquidity trap (if your textbook says so, congratulations! Most do not.) China, however, is not in a liquidity trap. Inflation is very likely to rise when wages rise, accompanied by a rise in money supply.

The consequences for balance sheets are clear. Nominal incomes will rise, which will allow more debtors to repay their debt, which is of course nominally fixed. The creditors will get their money back, but the purchasing power of that money will have decreased. This outcome is preferable to that of a financial crisis, which would have resulted from not inflating the economy, so capital owners should accept it as the better outcome. From an economic point of view, inflating comes with lower transaction costs than renegotiating all debt contracts and might therefore be the superior solution. Since debt contracts are all “changed” in the same way, it might also be more just.

Now we turn to the macroeconomic consequences of elevated inflation. The main equation here is Y = C + I + G + NX.

Net exports (NX) will probably go down slightly, as the domestic price level increases. This will lead to a re-balancing of the world economy, so that outcome is good.

Consumption (C) might rise if workers think they’re richer – they do get higher wages. Also, interest rates will remain quite low, as monetary policy is still expansionary. A boom of debt-driven consumption would definitely be in the cards, especially if real debt burdens fall at the same time. This has worked in countries as diverse as the US and Spain in the years leading up to a crisis.

Investment (I) is kind of exogenous, as most enterprises still get their capital from the government, either directly or indirectly. Since the nominal tax income of the government rises and its real debt declines as well, investment might go up or down. Let’s assume that the Chinese government adjusts investment in order to get aggregate demand to where it wants it to be. This would be “Keynesian” fine-tuning like most developed countries had in the 1960s.

Government spending (G) is also controlled by the government and can be used to either stimulate the economy and increase inflation, or to slow it down by restraining public investment.

This is just a back-of-the-envelope assessment of how China might move towards re-balancing its economy without having a financial crisis or other kinds of abrupt change. One of the main assumptions is that an inflation rate of 5-10% could be sustained without losing control over it. After all, the Chinese government has full control over the financial side and should be able to maintain a policy of sustained elevated inflation, as promoted (for other countries) by the IMF’s Olivier Blanchard, among others.

Inflating the Chinese price level would redistribute incomes from capital owners to workers and spur domestic demand, while also leading to a turnout as regards the external position. Imports would increase and exports decline because both domestic incomes and relative price changes would pull in the same direction. Note that in this scenario, given that the fixed exchange rate is maintained, foreign investors do get their money back at full (dollar) value. It might be the case that these Chinese policies would lead to higher global inflation as well, as some claim that policies of the past did lead to sustained lower inflation. In that case, purchasing power would decline on all financial assets, not only those in China.

Whether politics in China and other countries will allow this scenario of adjustment remains to be seen. However there is a road open for China that would lead to re-balancing, both domestically and internationally, which has some uncertainties. These must be compared to those of sustaining the export-led growth model, basically an even bigger currency mismatch in the PBoC balance sheet and ever more unproductive capital investments.

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About the Author

Dr. Dirk Ehnts is a research assistant at the Carl-von-Ossietzky University of Oldenburg (Germany). His focus is on economic integration and economic geography, covering trade, macro and development. He is working at the chair for international economics since 2006 and has recently co-authored a book on Innovation and International Economic Relations (in German). Ehnts has written at his own blog since 2007: Econblog 101. Curriculum Vitae.