Andy Xie unflinchingly describes China’s economy as overheated.
And if the country wants to avoid a banking crisis, he thinks it needs to crank interest rates ASAP.
Recent attempts to cool the economy have meant little since money is still too cheap for banks. The only way to truly cool things down is to make money more expensive, thus removing liquidity from the system.
Further, prolonged negative real interest rates – that is, rates below inflation – are the driving force of the bubble. Unless this is corrected, after a brief pause, the bubble will grow big again. Such a vicious cycle only ends when banks have insufficient liquidity – that is, households don’t increase their deposits but want to borrow as much as possible. Indeed, recent data suggests this scenario is coming.
The most effective actions for containing the bubble are: one, raising interest rates to above the expected inflation rate; and, two, raising capital requirements for banks. China should quickly raise interest rates by 2 percentage points; current rates are ridiculously low. When this is the case for too long, it leads to a property bubble, resource misallocation, and, eventually, a financial crisis.
China’s interest rates are probably five percentage points too low. Yuan appreciation expectations have provided money holders with a substitute for interest rates. Indeed, such expectations have driven up yuan demand so rapidly that the central bank has increased its foreign exchange reserves three times, to US$ 2.4 trillion, in the past five years. China’s asset prices have risen by about the same magnitude. Inflation has followed.
It’ll be painful in the near-term, but has to be done he argues. Read the full piece here >
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