To this date, there remains a lot of confusion whenever we say that the ability of People’s Bank of China (PBOC) to ease monetary policy has been constrained by what it appears to be a money outflow, which tightens liquidity within China automatically.
PBOC used to create money mainly as a result of foreign exchange intervention. During the time when there was huge pressure for Chinese Yuan to appreciate (in part due to trade surplus and persist foreign investment, and in part due to hot money), PBOC intervened to prevent Chinese Yuan from appreciating to quickly, and is forced to “print money” to purchase foreign currencies. This was how the foreign reserve accumulation worked for China, and the balance sheet expansion of PBOC was mainly driven by the increase of foreign assets (read our guide to China’s monetary policy).
To illustrate the point, the chart below shows the balance sheet (asset side) of PBOC and its major components. As you can see, the bulk of PBOC’s asset side is foreign assets, which is vastly difference from the balance sheet of the Federal Reserve, with its assets mostly in US Treasury securities (at least before the quantitative easing). The pace of expansion of PBOC balance was so fast that it increased by more than 450% from early 2003 when total assets amounted to a little more than RMB5 trillion to about RMB28.6 trillion at the end of June 2012.
Source: People’s Bank of China
Besides the observation that most of assets of PBOC are in foreign assets, it has become obvious that the pace of balance sheet expansion has slowed. The first notable and persistent slowdown in balance sheet expansion happened during the 2008/09 financial crisis, when the pace of PBOC balance sheet expansion has slowed from well above 30% yoy to around 10%. The most recent slowdown of the pace of balance sheet expansion is happening right now, with the size of balance sheet increased by less than 3% at June 2012 compared with the same month last year. The source of the current slowdown in balance sheet expansion is very obvious, which is the end of foreign assets accumulation, which drove much of the balance sheet expansion in the past.
Central bank’s balance sheet expansion is one way of easing monetary and financial condition, as we now all know in the QE-world. Balance sheet expansion eases monetary condition, while the lack of balance sheet expansion means lack of easing using balance sheet. The chart above tells you that PBOC has stopped using its balance sheet to provide monetary accommodation, and this is not intentional.
This result was unintentional. Foreign reserve accumulation in the past was necessitated by 1) the strength of Chinese Yuan; and 2) the desire of PBOC to weaken the strength of Chinese Yuan. The current situation has changed. Chinese Yuan is no longer expected to appreciate, and some people, particularly corporations, are now holding US dollar instead of converting it into Chinese Yuan. The size of trade surplus has also shrunk significantly after the financial crisis. Some of the rich households in China are also, for whatever reasons, seeking to emigrate by shifting some of their massive assets abroad. Finally, foreign direct investment is weakening while outbound direct investment increases. The first balance of payments deficit since 1998 confirm the same picture we gather from other statistics.
Together, these produce money outflow which we have been documenting in the past. We have to admit that we use the term rather liberally, as the outflow derived from the changes in the “position for forex purchases” in PBOC’s statistics does not distinguish the sources of outflow. It may well be hot money, or outbound investment, or perhaps local resident buying US dollar and holding it in a deposit account.
While most of these sources outflows are not in any way encouraged or intended by the government or the central bank, some have argued that outbound investment is not discouraged. One report even claimed that capital account deficit was “an intended result“. Recently, Barclays Capital also points out that outbound direct investment is encouraged and supported by the government.
However, some have massively misunderstood the impact of outflow. Even they might be an “intended” consequence of government policy in encouraging outbound investment (or whatever), that does mean it poses no negative consequence on liquidity in the Chinese banking system. Chinese companies might be doing acquisitions in other countries, thus they need to purchase foreign currencies and make acquisition, contributing to the money outflow we have been seeing. Motivations for making such acquisitions (and thus the money outflow) can be justified and very glorious indeed. However, a US$100 million outflow as a result of one rich household emigrating is the same as a US$100 million outflow as a result of a Chinese company making an acquisition in the United States. Whether the motivation of outflow is sinister or not makes no difference at all, and they have the exact same effect on PBOC’s foreign assets. Indeed, some of the money may not have really been moved out of the country (even though it shows up as if it were “outflow” in some accounts), but sitting in Chinese banks as foreign currencies deposits as companies start accumulating US dollar as they expect Chinese Yuan to depreciate.
Nevertheless, the impacts of outflow, outbound investment, weak foreign investment flow, accumulation of foreign currencies by households and corporations, and households moving money away for emigration on foreign assets of PBOC are the same. There is absolutely no point to distinguish the sources and motivations of various outflow as far as this big picture view is concerned.
We have to stress that the current pace of outflow is so slow that its negative impact on the size of foreign reserve is almost negligible, although it effectively has stopped PBOC’s balance sheet expansion. If the situation worsen (which is very possible), foreign reserve held by PBOC will eventually shrink much more meaningfully. The unintended consequence of such outflow is that it forces PBOC not to expand its balance sheet in the same way it did in the past many years, and such mechanism will force PBOC to withdraw monetary accommodation if foreign reserve drops. Thus even though the outflow is slow, and even though at least part of the outflow is motivated by some rather glorious reason such as national prestige (in making foreign acquisitions) or whatever, the negative impact on liquidity in the domestic financial system is the same, and the negative impact is already here. This is incontrovertible.
At the time when China is slowing down much worse than even the most pessimistic forecasters thought, the lack of central bank balance sheet expansion, which is an entirely unintended consequence, is unfortunate. Liquidity is tightened as bad loans increase, and the capital flow condition is no longer forcing PBOC to create base money in a way it did, which contributes to another source of tightening. This is a very negative development for the Chinese economy. Unless the PBOC at some point utilises other ways to expand its balance sheet in a much more substantial way, such a large asset purchase programme, PBOC will remain constrained in its ability to expand its balance sheet as it did, and cutting reserve requirement ratio and conducting reverse repo in a piecemeal fashion will likely be inadequate.
Of course, we will not know if the PBOC will do such thing until it really does, and there will certainly be many people arguing against any quantitative easing-like move by the PBOC on concern over inflation, or whatever. And as other developed countries’ experience show, central banks’ balance sheet expansion could be of little use in a debt deflationary environment, and China is already in one.
This article originally appeared here: Chinese central bank’s ability to ease monetary policy is constrained by outflow
Also sprach Analyst – World & China Economy, Global Finance, Real Estate
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