Stopping the leakages in China

I’m increasingly convinced that there’s a bunch of algorithms out there with instructions to trade as soon as the word “hike” appears on a Bloomberg headline. Doesn’t matter who hikes or what they hike—milliseconds later, the market reaction is all but predictable: Stocks down, dollar up, commodities down, Treasuries sell off.

Take the Fed’s move to hike the discount rate: No matter that the Fed had warned about this; no matter that it made crystal clear this was neither meant to, nor expected to, affect financial conditions; the kneejerk reaction was all of the above (though, thankfully, actual people with brains stepped in subsequently to restore some sense).

Anyway, the lack of significance in the Fed’s move is too obvious to be worth discussing. What I want to dwell on here is another hike—that by China—where the implications (or lack thereof) are a touch less obvious.

So, you may recall that, at the end of last week, and right before the Chinese New Year holiday, China hiked banks’ reserve requirement ratio (RRR) for the second time this year. Both times, we got the all-predictable market reaction above—the rationale being that China is stepping on the brakes, prompting a slowdown in domestic investment (especially in infrastructure and real estate), commodity imports and global growth.

But as it happens, China’s RRR hikes have virtually zero impact on the country’s financial conditions. Indeed, as I’ll argue below, China has yet to show any signs that it is serious about avoiding overheating and asset bubbles in its economy in an effective and sustainable way.

I’ll start from the (non-)impact of the RRR hike first. In theory, a higher RRR can work to curtail credit growth in two ways: First (and most importantly), by affecting the price of lending—by reducing the average interest banks earn on their assets, it effectively forces them to raise lending rates to maintain their profitability. And second, by putting a ceiling on the quantity of funds/deposits available for lending.

However, in the case of China, both these channels are broken. Starting from the price, with interest rates prescribed "from above", lending rates have not budged since the end of 2008, when they were cut sharply to forestall an impending downturn. So no tightening there.

When it comes to the quantity of new loans, the authorities have set a target for new loans in 2010, at CNY 7.5 trillion. This is the second biggest ever (after last year’s CNY 9.6 trillion) and at least twice as high as in 2005-07, when GDP growth rates stood at double-digits. So, again, not exactly tightening.

Importantly, given the quantitative target for new loans, the hike in the RRR is in theory redundant: Once you have put a ceiling on new loan creation, what’s the point of trying to control quantities through hikes in the RRR?

In practice there may be a “point”... First, the authorities’ track record of enforcing their quantitative targets is less than stellar. For example, last year, new loans exceeded the target by almost 100%!

This year they’re trying harder: According to local press reports, regulators are closely monitoring new loan creation with a 30/40 rule, under which new loan creation in each quarter cannot exceed 30% of the whole year’s quota; and new loan creation in each month cannot exceed 40% of each quarter’s quota. Arguably, the hike in the RRR can provide an additional source of restraint in banks’ ability to lend…. But does it?

No. And here is why: What the RRR does is place an upper bound to the times a given amount of new deposits can be “multiplied” into new loans—all else equal, including interest rates, project riskiness, banks’ liquidity preferences, etc. In the case of a RRR of 15.5% (that’s the simple average of China’s 14.5% for small banks and 16.5% for large ones), this “multiplier” is equal to 5.5 times (=(1-RRR)/RRR).

That’s not really binding. Consider this: With the current RRR, it just takes a deposit “base” of CNY 1.3 trillion (or US$200 billion) to create new loans of CNY 7.5 trillion, China’s quantitative target for 2010. But the annual flow of new deposits is much higher than this, due to China’s commitment to a fixed exchange rate regime: Indeed, PBoC data show that some US$200 billion of (largely unsterilized) flows have entered the system in the six months to November 2009 alone (perhaps a little less, if one takes into account valuation effects).

Unless the inflows are either sterilized (which would require higher interest rates) or meaningfully reduced (via a CNY appreciation), “leakages” in new loan creation seem all but inevitable. Mind you, not just new loan creation.. excess liquidity can also be directed to the stock market or real estate assets at home or in Hong Kong, fuelling bubbles—already a concern for many investors and policymakers in Asia and elsewhere.

Bottom line, China’s recent measures fall way short of sending a signal that it’s serious about preventing overheating and asset bubbles. Quantitative and administrative measures can go only as far. The real McCoy would be a hike (or multiple hikes) in interest rates, and soon… much sooner than the Fed, which, in my humble opinion, is not moving on the rates front till next year, barring major surprises in inflation expectations or employment.

In turn, this means the exchange rate will have to give: Controls on capital inflows will fail to stop hot money from coming in, right as the tightening cycle is about to begin.

Is that the course of action the authorities envisage? Nobody knows. But in the meantime, the one advice I can give to all those algorithmic traders out there is that it may be time to expand your "vocabulary".