(emphasis mine)

China's Financial Repression
by James A. Dorn
May 22, 2008

China's phenomenal rise since 1978 has resulted from economic liberalization, not monetary ease.

But China is still not a full-fledged market economy, and monetary policy is compromised by Beijing's reluctance to let market forces determine interest and exchange rates.

In a world of mobile capital, using monetary policy to peg exchange rates makes it more difficult to control inflation. Real economic development requires stable money and economic freedom, which expand the range of choices open to individuals.

Congress should recognize it is in China's own interest to let the yuan appreciate faster in order to avoid inflation.

Inflation is now at a 12-year high. The consumer price index rose 8.7 percent in February, from a year ago, due primarily to higher food prices. The real threat to China's long-run price stability, however, is not from the risk of higher food prices, or other increases in relative prices, but from excessive growth of money and credit.

By undervaluing the exchange rate and keeping real loan rates artificially low, China risks fueling inflation. Meanwhile, price controls designed to suppress inflation are distorting relative prices, creating shortages and breeding corruption.

Though China announced a major change in its exchange-rate regime in July 2005, and told the world it would henceforth manage its currency by pegging to a currency basket as opposed to the U.S. dollar, Congress has been impatient. Bipartisan legislation threatens to penalize China for "currency manipulation."

Presidential hopefuls Hillary Clinton and Barack Obama have joined the anti-China chorus and said they would co-sponsor a bill to treat the undervalued yuan as an actionable subsidy.

Congress should recognize it is in China's own interest to let the yuan appreciate faster in order to avoid inflation. When the yuan's value in dollars increases, it means the People's Bank of China (PBC) does not have to create as much domestic currency to buy dollars. In this way, money and credit growth can be tamed without administrative controls and without risking further inflation.

While the yuan has been allowed to appreciate by 18 percent against the dollar since 2005, China's foreign exchange reserves have more than doubled from $819 billion to $1.8 trillion today. The PBC has "sterilized" capital inflows and kept the monetary base (currency held by the public plus bank reserves) from explosive growth.

In particular, the PBC has been able to restrict the growth of money and credit by selling bills to state-owned banks, increasing reserve requirements, rising loan rates and enforcing credit quotas. Beijing has supplemented those forms of financial repression by imposing price controls on foodstuffs and energy.

Using sterilization and administrative measures to implement monetary policy is far from optimal. China's reluctance to let the yuan float means monetary policy cannot be devoted solely to preventing domestic price inflation. Indeed, that task becomes even more difficult as capital controls are relaxed or evaded, and as China's trade sector grows and financial innovation occurs.

China needs a more transparent monetary policy aimed at achieving long-run price stability. The stop-go monetary policy of the 1980s and '90s is less severe today because the PBC has been able to slow the growth of money and credit, but only by flooding the balance sheets of state-owned banks with PBC bills, crowding out alternative investments, and imposing credit quotas.

Financial repression and price controls are denying China the opportunity to increase economic freedom and prosperity. Interfering with market prices — whether in the form of undervaluing the exchange rate, capping interest rates, or controlling the relative prices of products, services and resources — weakens property rights, politicizes economic decisions, and leads to corruption. Those in government who administer the controls gain power, while the people lose wealth and freedom.

Using capital and exchange controls, credit quotas and price ceilings to substitute for a transparent monetary policy aimed at price stability is becoming more costly, as China's economy grows and becomes more integrated with the global economy. The challenge for Chinese leaders will be to let go of the legacy of central planning and adhere to a market-based monetary policy that allows price flexibility while maintaining sound money and economic freedom.

The CATO Institute also reports about the costs and implications of pbc sterilization.

THE COSTS AND IMPLICATIONS OF PBC STERILIZATION

China's International Payments Imbalance

In the period prior to 2002, there were few presumptions that China's currency would appreciate. There had been a long history of devaluations between 1960 and 1994. However, following the devaluation of 1994 and the subsequent monetary reforms the external value of the currency was held stable against the US$, notably throughout the Asian financial crisis of 1997-98. Nevertheless, the NDF (non-deliverable forward) value of China's currency traded at a persistent discount to the spot value of the currency (that is, weaker than the spot rate of around 8.27 per US$) until December 2002 when it moved to a premium for the first time (Figure 1). In the same year, the errors and omissions item in China's balance of payments shifted from negative to positive, suggesting a change from unreported outflows to unreported inflows. In 2003 and 2004 both the current account and the capital account showed marked increases in the size of their surpluses.

Since the revaluation of July 2005, and despite the gradual subsequent appreciation of the RMB against the U.S. dollar and other currencies, the low level of the Chinese currency is causing China to run increasingly large overall (current plus private sector capital account) surpluses in its balance of payments. The simplest measure of that overall (current and capital) surplus is the increase in China's foreign exchange reserves.1 In 2006, the overall surplus was $246 billion or 9.1 percent of GDP, while the current account surplus was $249 billion or 9.2 percent of GDP (Table 1). In 2007, the current account surplus increased to $371.8 billion or 11.1 percent of GDP. Similarly, the overall surplus in 2007 was $461.7 billion, or 13.8 percent of GDP. By any standard, these imbalances are of a very substantial magnitude, and will have large consequences for both China's trading partners as well as for China itself.

PBC's Sterilization Techniques

The overall surpluses in the balance of payments require the PBC, China's central bank, to intervene almost daily and buy any excess foreign currency on the Shanghai foreign exchange market in order to hold down the value of the RMB. Based on 250 trading days per year, the PBC's foreign exchange purchases exceeded $1.8 billion per day in 2007. In making these purchases, the PBC typically credits the reserve accounts of mainland banks with an equivalent amount of RMB, which in the normal course of events would cause China's money supply to accelerate (as in 2002-03), and this in turn would normally lead to inflation. The inflation-if permitted-would at some point render China uncompetitive at the prevailing exchange rate, and the balance of payments would revert to balance or even deficit.

However, having experienced several episodes of monetary acceleration, inflation and its aftermath (in the form of social disturbances) in the past three decades (for example, in 1988-89 and 1993-95), the Chinese authorities seem nowadays determined to implement monetary policy in such a way as to avoid the same sequence of results. Therefore, after buying foreign currency and thus creating RMB, the PBC subsequently removes the RMB from the banking system. It has learned the techniques for doing this from other Asian central banks that have routinely conducted such sterilization operations over the past two or three decades.2

The essence of the PBC sterilization techniques is (1) to raise reserve requirements against deposits of commercial banks, and (2) to issue RMB-denominated bills and bonds (called sterilization bills or bonds) to the banks and other financial institutions. As of May 2008 the level of reserve requirements was 16.5 percent of bank deposits (up from 6 percent in 2003), while the value of sterilization bills had reached 10 percent of bank deposits. In total, therefore, no less than 26.5 percent of Chinese commercial banks' deposits is immobilized, or placed with the central bank. Figure 2 shows that if the level of total reserve requirements and the volume of outstanding sterilization bills are summed, the results are approximately equal (in US$ terms) to the value of China's foreign exchange reserves. In short, under current operating procedures the value of sterilization instruments outstanding increases roughly in line with the level of foreign exchange reserves.

figure 2
PBC Foreign Reserves and Sterilization Instruments (US$ Billions)


Costs and Benefits of PBC Sterilization

Sterilizing inflows is not a costless procedure. In fact, it leads to significant distortions that may be highly costly to correct in the long run. The question is: What kinds of distortions are created by the sterilization operations? Here I focus on four.

Distortions Created by Sterilization

First, by keeping the undervalued currency cheap, sterilization tends to encourage over-expansion of the export sector, while inflation (or real exchange rate adjustment) in the pegging country-China-is delayed. As a corollary, numerous domestic sectors such as housing, health care, education, entertainment, and other nonexport-related infrastructure investment are restricted below their optimum size. Corresponding but converse misallocations will occur in the economies of China's trading partners.

Second, parallel to these real-sector distortions, there are significant financial-sector distortions. Sterilization distorts interest rates and the asset portfolio of Chinese commercial banks. Instead of lending to normal commercial customers such as firms and individuals, the banks are compelled (by higher reserve requirements) or induced (by purchase of PBC sterilization bills) to lend money back to the central bank. The absorption by the PBC of these excess RMB (created from the PBC's intervention operations) implies some distortion of interest rates, typically keeping them at higher levels than would otherwise be the case.3 This outcome is part of the process that prevents the expansion of bank lending and money growth, and thereby appears to delay or prevent any upturn in inflation.

Third, the central bank balance sheet expands massively as it absorbs funds from the banks and invests the proceeds in foreign exchange reserves. In China's current circumstances, the accumulation of foreign exchange assets by the central bank is taking the place of increased domestic spending by Chinese firms and households, which would in turn give rise to greater imports, reducing the overall payments imbalance. Alternatively, in contrast to the case where the RMB is allowed to appreciate and Chinese firms and individuals are free to buy assets abroad, the official stockpile of foreign exchange reserves is replacing the acquisition of a more diversified, higher return portfolio of foreign assets (such as businesses, factories, real estate, and natural resources) by the Chinese commercial sector.

Fourth, overseas the accumulation of large volumes of U.S. Treasuries by China and other countries with rapidly growing foreign exchange reserves has reduced the yield on U.S. Treasuries and similar assets below what they would otherwise be. This result, of course, is part of the explanation for Greenspan's conundrum concerning "the broadly unanticipated behavior of world bond markets"-that is, the unexpectedly low yields in bond markets in recent years. Ben Bernanke and others have referred to this phenomenon as a "global savings glut."

I now turn to make an assessment of China's sterilization by answering a series of questions.

Does Sterilization Achieve Its Ultimate Objectives? Does It Fend Off Unwanted Business Fluctuations and Undesirably High Inflation?

By continuing to maintain its currency at below-equilibrium levels, China's overall balance of payments can be balanced only by large outflows in the form of official acquisitions of foreign assets. With China's currency managers focusing primarily on the RMB/US$ axis and the US$ falling, the Chinese currency has failed to appreciate as much as many countries (for example, in Europe) might have expected, aggravating any undervaluation of the RMB and further increasing China's trade surpluses. The end result will be further expansion of the export sector, and a spillover of spending from higher profits and wages in the export sector into the domestic sectors of the economy. In effect, overheating will eventually emerge, but by different channels-primarily through spillovers from export-led growth rather than directly from domestic demand growth.

To put it another way, sterilization suppresses the monetary expansion that would otherwise occur under conditions of an undervalued exchange rate, but it cannot prevent other needed economic adjustments. The fact that there is an overall balance of payments surplus is a signal that the economy is super-competitive at current exchange rates. To return to an equilibrium level of competitiveness without exchange rate adjustment, either the domestic price level must adjust via monetary expansion and inflation, or the export sector must expand until the incremental spending (from raw material procurement, as well as increased wages and profits) spills over into other sectors sufficiently to produce the same result.
…
What Happens When the Central Bank Starts to Unwind Sterilization?

The outstanding stock of bills and bonds issued by the central bank would gradually be allowed to mature, and at maturity the overhang of liquidity that had been bottled up by the central bank would start to flow back to the commercial banks. Bank lending and monetary growth would accelerate, and the suppressed inflation would emerge. It was at this stage in the mid-1990s that Malaysia's problems became serious. In the space of a few months bank lending to the private sector accelerated from 10 percent per annum to over 30 percent per annum. At the same time monetary growth accelerated sharply. This rapid growth of money and credit contributed directly to the problems of overheating and overinvestment that later precipitated the Asian financial crisis of 1997-98.
…
China's exchange rate mechanism is clearly of the intermediate kind, and, as I have shown, the extent of intervention required has become so enormous as to require in turn very extensive sterilization operations. Sterilization implies the deliberate postponement of the adjustment of an economy's domestic price level or external exchange rate to changes in the international economy.

My reaction: Some key points to note:

1) The is a huge amount of pent-up inflation in China.

2) Understand the true cost of the dollar peg: as of May 2008 no less than 26.5 percent of Chinese commercial banks' deposits was immobilized, or placed with the central bank.

3) When inflation does start growing again, China won't be able to raise interest rates to contain it. With the fed and other central banks around the world having set their interest at or near zero, if China starts raising interest rates it will attract all the hot money in the world (Hot money = money that flows regularly between financial markets in search for the highest short term interest rates possible). Since these hot money inflows would force China to print even more yuan to maintain its dollar peg and increasing the money supply, raising interest rates will be of no help in fighting 2009's inflation.

4) Out of a misguided fear of deflation, China is unwinding its sterilization. Expect bank lending and monetary growth to accelerate, causing China's suppressed inflation to emerge.