Risks and opportunities
The U.S. subprime mortgage crisis has become a global credit crisis that China cannot escape. Fortunately, 30 years of economic liberalization and opening up to the outside world have made China stronger and more resilient to outside shocks. China’s leaders are to be congratulated for allowing greater economic freedom, which has helped millions of people escape poverty. Trade has expanded individual choices and given people new opportunities to improve their lives. It has also increased personal freedom.
While central planning has largely disappeared, it is still present to some degree in the financial sector. Macroeconomic prices‐interest rates and the exchange rate‐are heavily influenced by government policy, and the yuan is not fully convertible. Capital controls allow the central bank to peg the exchange rate and at the same time sterilize capital inflows to prevent inflation. Nearly all banks and non‐bank financial institutions are state owned and controlled, though large banks have been turned into shareholding firms in which private investors can take minority positions.
China’s “financial repression” means that the financial system is characterized primarily by market socialism, not market liberalism, which poses a risk for future development. Just as the socialization of risk and the privatization of profit in America’s GSEs helped precipitate the credit crisis, the same could happen in China. Although large state‐owned banks have been recapitalized and marketized to a degree, they remain creatures of the state. If they become insolvent, taxpayers will be the victims.
China will only be able to have an independent monetary policy aimed at long‐run price stability, which fosters financial stability, if it floats the yuan and eventually allows full convertibility. Under the present regime, in which the yuan is undervalued, the People’s Bank of China (PBOC) must buy dollars by increasing the supply of domestic currency. Firms are limited in the amount of foreign exchange they can hold, so the opportunity to increase domestic consumption through imports is restricted while expansion of the PBOC’s balance sheet crowds out private investment. To prevent inflation, which would occur under a fixed exchange rate regime, the PBOC must withdraw liquidity by selling central bank bills or increasing reserve requirements. Sterilization, however, distorts interest rates and delays the appreciation of the real exchange rate by suppressing inflation, which is the only route adjustment can take if the nominal rate is pegged. In addition, sterilization prevents banks from lending to the private sector since they must accumulate reserves and hold central bank bills.
A final distortion is that financial repression has led China to hold massive amounts of U.S. treasury and agency debt, which has kept U.S. interest rates lower than they would have been, thus helping to bring about the housing boom.
In a recent article in the Cato Journal, John Greenwood, chief economist at INVESCO, considers each of these distortions and warns that suppressed inflation, the bottling up of liquidity by the central bank, eventually will surface. When it does, capital could flee China and the boom could turn into a crisis. The 1997–98 Asian financial crisis was preceded by excessive growth of money and credit, which led to overheating. China can buy time with capital and exchange controls, and by using credit quotas and price controls, but only by distorting the real economy. According to Greenwood, “In China’s case, the controls on capital flows may for a time prevent such a sudden reversal of capital flows and drastic adjustment as occurred in the Asian financial crisis of 1997–98, but the key point remains. Allowing an extended period of overinvestment in one or two sectors that ultimately produces unacceptably low returns can shift a currency from being perceived as undervalued (as with the RMB today) or appropriately valued (as in the case of Asian currencies in 1996–97) to being suddenly overvalued.”
Although consumer price inflation has slowed and China’s asset bubble in the stock market has most likely been deflated, housing prices in major cities have skyrocketed over the last several years, and the growth of money and credit continues to be strong. With pressure to lower interest rates and reserve requirements to “stimulate” the economy, the PBOC will face some difficult choices.
Because of the PBOC’s commitment to defend the foreign exchange value of the yuan and prevent it from appreciating at a politically unacceptable rate, the monetary authorities are limited in their ability to use the bank interest rate to control inflation. Raising the rate would simply attract more capital that would have to be sterilized to control money growth‐so reserve requirements and direct controls are used to limit bank lending.
Although the yuan has appreciated more than 20 percent against the dollar since July 2005, the rapid increase in foreign exchange reserves, which now total more than $1.8 trillion, implies that the yuan is still undervalued. For a capital‐poor country like China to invest billions of dollars in low‐yielding U.S. government debt is wasteful and risky, especially if the U.S. financial crisis becomes a fiscal crisis and inflation is used to reduce the real burden of the debt.
The longer China delays creating real capital markets and allowing relative prices, especially interest rates and the exchange rate, to be freely determined, the more costly the final adjustment will be. As Greenwood emphasizes, “[Sterilization] is no more than a temporary palliative, buying financial stability at the cost of real distortions.” Fortunately, China’s leaders appear to recognize that danger and are gradually relaxing capital controls, liberalizing interest rates, allowing greater flexibility in the exchange‐rate regime, and lifting price controls. The most difficult, but most important, task will be to privatize state‐owned banks and allow owners, not taxpayers, to bear the risk of loss. In this regard, the United States is not setting a very good example.
The present trend in the United States is to move toward market socialism and away from market liberalism. That departure from free‐market principles could present China with a novel opportunity to become the world’s largest capital market. To do so, however, would mean getting rid of what Adam Smith called “all systems of preference or of restraint” and allowing the “system of natural liberty” to emerge.
The way forward
Long before Adam Smith wrote The Wealth of Nations, China’s great historian Sima Qian wrote The Biographies of the Money Markets, in which he advocated a laissez‐faire approach to organizing economic life. Drawing on Taoist thought, he wrote, “When all work willingly at their trade, just as water flows ceaselessly downhill day and night, things will appear unsought and people will produce them without being asked. For clearly this accords with the way and is in keeping with nature.”
The question of financial stability is ultimately one of balancing state and market. Government is necessary to protect persons and property and to enforce contracts. But if the state socializes risk while privatizing profits, the delicate balance of risk and responsibility will be upset. Instead of creating harmony, government intervention will negate the spontaneous market order and destroy the Tao of the market‐undermining freedom and prosperity.
The global financial crisis that began in the U.S. housing market is not a failure of market liberalism, but of market socialism. Prior to central banks, the international gold standard worked spontaneously to bring about a balance between the demand for and supply of money. That system was not perfect, but it did help generate sound money, limit the size of government, and expand trade.
In theory, central banks can control the supply of paper money and prevent inflation, but will they have the political will to do so? Without effective constraints on central bank discretion, there is no guarantee that fiscal pressures will not lead to an abuse of the monetary authorities’ power.
One should recognize that there are limits to monetary policy and to regulation. Policymakers need to recognize those limits and learn from the current crisis as well as past crises. Financial harmony requires a system based on private property in which owners, not taxpayers, bear the losses and capture the gains from investment decisions. All individuals seek to improve their lives. When that natural instinct is harnessed by a rule of law protecting persons and property, free trade will lead to mutual gain. China’s quest for “social harmony” will be furthered by following the Tao of the market and adhering to the rule of law, not by rigidly adhering to a “socialist market economy.”
Many great economists from Adam Smith to Vernon Smith have expounded on the spontaneous market order and its benefits for freedom and prosperity. The failure of central planning in the Soviet Union and elsewhere led China and other nations to make the transition from plan to market.
The challenge will be for China and other emerging market countries not to succumb to greater central planning of financial markets, but to structure incentives and institutions so that individuals can coordinate their saving and investment decisions efficiently through private free markets.