China In Transition explains why China's room for sterilization is diminishing.
(emphasis mine) [my comment]
China Faces a Tough Challenge in the Steering of Monetary Policy - The room for sterilization is diminishing
(August 23, 2006)
by Chi Hung KWAN
The People's Bank of China (PBOC, China's central bank) has continued to intervene in the foreign exchange market at a massive scale, buying as much as $200 billion per year (equivalent to its balance-of-payments surplus) to maintain the yuan's exchange rate against the U.S. dollar [This amount has grown. Today, China is buying dollars at an annual rate of around 500 billion, and the pace of these dollar purchases is increasing with its growing trade surplus]. Consequently, China's foreign reserves reached $941.1 billion in June 2006 and are certain to exceed $1 trillion before the end of the year. The resulting excess liquidity has been contributing to the overheating of investment and the expansion of an asset bubble, presenting the central bank with a difficult challenge in steering monetary policy.
Dollar-buying intervention for the purpose of holding down upward pressure on the yuan is nothing other than the PBOC letting out base money (see note 1 [at the end of article]) to the market in exchange for U.S. dollar. Massive intervention of $200 billion per year has been directly boosting the amount of base money by 1.6 trillion yuan ($1 = 8 yuan) a year, which represents an annual increase of approximately 30%. When the money multiplier (see note 2) is assumed constant, the broad money supply (M2) is to increase in proportion to the amount of base money.
To prevent excess liquidity and offset the rise in money supply resulting from intervention, a central bank must opt for "sterilization" policy. The most typical method (sterilization in a narrow sense) is to withdraw base money through open market operations: selling of government and/or central bank bills in the market (see note 3). The simultaneous conduct of intervention and sterilization (open market operations) is called "sterilized intervention," whereas intervention unaccompanied by sterilization (open market operations) is called "unsterilized intervention."
The interrelation among intervention, sterilization, and sterilized intervention can be confirmed by tracking the changes in the central bank's balance sheet accompanying them (see table 1). Intervention increases the amount of dollar-denominated assets (foreign reserves) and base money, a liability item, whereas sterilization (open market operations) reduces base money and instead increases central bank bills (see note 4). Sterilized intervention—intervention combined with sterilization—results in an increase in dollar-denominated assets as well as in central bank bills, a liability item. As such, the difference between (unsterilized) intervention and sterilized intervention is what the central bank supplies to the market in exchange for absorbing dollar-denominated assets, namely, highly liquid base money in the former case and central bank bills with low liquidity in the latter
At this stage, opinions are divided as to whether sterilization in China has been a success as different criteria lead to different evaluations. While base money in June rose 10.0% from the same month last year, increase in CPI remained at a relatively low level, posting a year-on-year increase of 1.0% in July. Judging from this, it may appear sterilization has been successful. At the same time, however, M2 growth accelerated from 14.6% in 2004 to 18.4% in July 2006, reflecting a rise in the money multiplier resulting from the lowering of the cash-deposit ratio as well as of the (excess) reserve-deposit ratio. Against this backdrop, the overheating of investment shows no sign of easing, and property and stock prices are surging. In this sense, it is hard to say that sterilization has been a success.
Furthermore, because intervention is so enormous in scale and has been conducted over a prolonged period, it is becoming increasingly difficulty for the PBOC to implement sterilization operation to keep the money supply under control.
First, in order to make up for the shortage of government securities to sell in open market operations, in April 2003 the PBOC began to issue central bank bills (PBOC bills), the volume of which has been increasing rapidly thereafter. As of June 2006, the amount of PBOC bills outstanding stood at 2.86 trillion yuan, equivalent to 45.4% of base money and up 1.2 trillion yuan from a year earlier (see figure 1).
Second, the maturity of PBOC bills is becoming longer; most PBOC bills issued in the initial stage had a maturity of three months, but those with one-year maturity have now come to represent the largest portion. This means that the borrowing cost on the part of PBOC is increasing because the long-term interest rates are higher than the short-term rates.
Third, the yield at issue of PBOC bills is beginning to rise. As of this August 15, the yield at issue of the one-year PBOC bill stood at 2.7961%, up 0.9% from the beginning of the year. The rise in interest rates may trigger a vicious cycle, attracting further capital inflows thereby forcing the central bank to further expand the scale of intervention and sterilization.
Lastly, several times since May this year, the Chinese central bank has issued PBOC bills by means of a "targeted issue" scheme in combination with selling at auction. The targeted issue scheme is to force specific targeted commercial banks to underwrite PBOC bills at a yield lower than prevailing market rates. For instance, on June 14, the PBOC made a targeted issue of one-year maturity bills worth 100 billion yuan at a yield of 2.1138%, 0.4% lower than the then prevailing market rate. Of the PBOC bills issued, 42 billion yuan worth were to be purchased by the China Construction Bank, 30 billion yuan by the Agricultural Bank of China, 12 billion yuan by the Industrial and Commercial Bank of China, 10 billion yuan by the Bank of Communications, and the remaining 6 billion yuan by others. Banks posting a higher increase in lending have a greater chance to be targeted in the scheme. Forced underwriting of PBOC bills at a lower interest rate is operating as a sort of penalty to these banks.
In conducting monetary policy in the presence of enormous balance-of-payments surplus, China is faced with the three choices of (1) sterilized intervention, (2) unsterilized intervention, and (3) allowing the yuan to rise (see figure 2). If there are no changes to the foreign exchange policy, China's foreign reserves are expected to increase by more than $200 billion every year, making sterilized intervention even more difficult. With room for further sterilization diminishing, China is being compelled to decide either to let the yuan appreciate at a faster pace while scaling down the intervention, or to accept excess liquidity and the resulting rise in goods and asset prices by continuing the intervention but giving up on sterilization (unsterilized intervention).
Base money is the sum of currency in circulation and the reserves held by depository institutions at the central bank. It is also called monetary base or high-powered money. Monetary policy is conducted by means of increasing (easing) or decreasing (tightening) the base money supply.
The money multiplier is the size of broad money supply (M2) relative to the size of base money. The lower the cash-deposit ratio and reserve-deposit ratio (the sum of the statutory reserve-deposit and excess reserve-deposit ratio), the higher the money multiplier.
Apart from open market operations, the Chinese central bank has at its disposal diverse means of sterilization in a broad sense (monetary tightening measures) to absorb excess base money resulting from massive interventions, including the manipulation of interest rates, changes to the reserve requirements, "window guidance," and "moral suasion." Specifically, the PBOC raised lending rates of banks three times in succession, by 0.27% each on October 29, 2004, April 28, 2006 and August 18, 2006 (the one-year benchmark interest rate has been raised from 5.31% to 5.58%, 5.85% and then to 6.12%). At the time of the third raise, the PBOC also hiked deposit rates. Additionally, the reserve-deposit ratio has been raised three times since September 2003, a total of 2%.
When a central bank conducts open market operations by means of selling its holdings of government securities, rather than issuing central bank bills, both the amount of base money (liability) and the amount of government securities (asset) on the central bank's balance sheet will be reduced.
Stratfor reports about China's mounting losses from currency sterilization.
China: Mounting Losses from Currency Sterilization
February 1, 2008 1817 GMT
MARK RALSTON/AFP/Getty Images
In the face of falling interest rates in the United States and rising interest rates in China, Goldman Sach' s China economist, Hong Liang, has estimated that Beijing is losing approximately $4 billion each month in its foreign currency “sterilization” operations, the Financial Times reported Jan. 31. This is because China' s foreign exchange reserves are still expanding faster than its economy.
To maintain a grip on its currency, Beijing has been absorbing most foreign currency flowing in through export income by buying the currency with yuan. By issuing yuan-denominated bills — the equivalent of U.S. Treasury bills — at home, Beijing takes foreign-currency liquidity out of the Chinese economy. Until recently, such “sterilization” operations had been profitable, since the rate of interest that Beijing earned on U.S. Treasury assets (into which it had invested its foreign exchange reserves) had been higher than the rate of interest it was paying out on the yuan-denominated assets issued at home.
Recently, however, as the U.S. Federal Reserve began lowering its interest rates to combat U.S. economic uncertainty [now 0 percent], the People' s Bank of China began raising interest rates to combat rising inflationary pressures [now 5 percent] (a recent Bank of China report predicts yet another Chinese rate rise in February). If this continues, China' s previously profitable local-currency policy will soon (if it has not already) become a loss-making policy [China now gets 0 percent from its treasury purchases, yet it has to pay over 5 percent for its domestically issued debt].
In light of the profits it has made from its sterilization policy, and the alternative methods it can use to control inflation instead of raising interest rates (such as increasing the amount of money that local banks must put aside as spare reserves), Beijing can easily handle the magnitude of any such losses [not anymore it can't]. But U.S. political pressure for, and internal party debate over, China' s existing yuan policy has been rising. Hence, just a marginal rise in bottom-line pressures might be all it takes to cement an even bigger change in China' s local currency strategy than the 8 percent to 10 percent appreciation recently estimated for 2008 by the People' s Bank of China. And this could come just in time to be approved in March at the National People' s Congress.
My reaction: Things to take away from these two articles:
1) An understanding of how China's currency intervention and sterilization work.
2) China's foreign exchange reserves are still expanding faster than its economy. In fact China's economy is shrinking while its foreign exchange reserves are growing faster than ever.
3) China now gets 0 percent from its treasury purchases, yet it has to pay over 5 percent for its domestically issued debt. China is getting royally screwed in this deal.
Here is another chart showing how China sells debt to absorb the money it prints to buy dollars:
In addition to selling PBOC bills, China's sterilization efforts have included all of the following
China has instituted credit ceilings on bank lending.
Because of efforts like this to contain bank lending, the Chinese M2 is only about 60% of the American M2, despite the Chinese M1 being about equal to the American M1. Basically, this means that Chinese financial system is underleveraged compared to the US.
China has kept interest rates high and imposed onerous requirement to contain inflation
To contain skyrocketing housing prices, China has kept interest imposed a 30% down payment requirement for second mortgages to try to suppress real estate price. Even now with inflation slowing down, it is not lifting these restrictions or lowered interest rates below 5 percent.
Unlike with the US, the Chinese housing price slump was and is a deliberate policy decision by the government. If the Chinese government wanted to boost housing prices, it could instantly do so by lowering the down payment requirement to 20% and dropping the interest rate to 2 or 3 percent. By contrast, the US has already lower its interest rate to 0, has no down payment restrictions and has issued a number of tax incentives in a vain attempt to save its housing market. All this means that China's real estate market is being artificially suppressed by high interest rates and down payment.
China has raised the reserve ratio requirements of banks
China has been raising the reserve ratio requirements for banks, which shrinks the money multiplier (see note 2 in article above). A side of effect of doing so means that Chinese banks now have large capital cushions compared to banks elsewhere like the US.
China has restricted consumer lending
The lack of consumer credit in the Chinese economy drastically slows the velocity of money because everything must be paid for in cash. Also, without being able to borrow easily, Chinese are forced to save money to pay for unexpected expenses, resulting in China having one of the highest savings rate in the world. In contrast, most Americans just put unexpected expenses on their credit cards and so have no immediate need to save. Any Chinese efforts to change this policy and boost domestic spending will therefore decrease savings and increase the velocity of money in China, producing inflation.
China's sterilization efforts and its attempts to boost domestic spending are mutually exclusive. If China gives up its sterilization efforts, it will also need to stop printing money to support its dollar peg or else there will be rampant hyperinflation. China's choice is to either watch its economy fall apart as exports collapse, or drop its sterilized currency intervention efforts to focus on domestic demand.