Andy Xie gets it!
China: Dealing with Too Much Money
Andy Xie (Hong Kong)
China’s financial system still has excessive liquidity, mainly due to capital inflow. Surplus liquidity probably exceeds one trillion yuan. Considering that projects worth trillions of dollars have already been approved, overheating in the economy could, we believe, get considerably worse.
Another hike in the deposit reserve requirement is, in our view, unlikely to solve the problem. The source of liquidity is capital inflow for currency and property speculation. Effective measures must tame speculative enthusiasm, which could decrease or reverse capital flow.
Two policies could be effective, we believe. First, the government could announce that the currency peg will stay for the next five years while it focuses on financial reforms. Such a policy would, in our view, be likely to halt the inflow of hot money immediately.
Second, the government could impose an 80% capital gains tax on property sales within the first year of their acquisition and ten percentage points less for every additional year between acquisition and sale. Such a policy would, in our view, encourage long-term ownership and help eliminate speculation, which artificially inflates property prices and hurts the majority of people.
Massive Surplus Liquidity
Financial institutions increased lending by 2,260 billion yuan last year, compared to 2,770 billion yuan in 2003. Holdings of securities (mostly government and development bank bonds) increased by 68 billion yuan compared to 347 billion in 2003. In addition, foreign currency loans increased by US$5.1 billion compared to $27.2 billion in 2004.
In total, the financial system injected 2,370 billion yuan in new money into the real economy last year, down from 3,342 billion in 2003. The total was 2,449 billion yuan in 2002 and 1,801 billion in 2001. There was a significant slowdown in loan creation last year.
The potential supply, however, did not decrease by much. Deposits in the financial system increased by 3,247 billion yuan in 2004 compared to 3,714 billion in 2003. The ratio of loans plus securities holdings to deposits declined to 86.6% last year — a historical low. If the ratio could rise to 92% as in 2002, the financial system could increase loans by 1.4 trillion yuan without additional deposits. Taking into account the increase in the deposit reserve ratio, the surplus liquidity in the system could still exceed one trillion yuan.
The Economy Could Become More Overheated
The rapid increase of foreign exchange on the liability side has become the main driver of liquidity. It accounted for 48% of the increase in financial liability — a historical high. This is the main reason that the growth in financial assets amounted to 237% between 2000 and 2003.
Speculative capital inflow is the primary reason for the rapid increase in foreign exchange in the financial system. China reported US$88 billion in trade surplus between 2002 and 2004, but forex reserves increased by $443 billion during the same period.
Every local government has a blueprint for its city. Its incentive is to get as many projects started as possible. This is why, when money is available, it has a tendency to be used for investment regardless of its financial returns. The surplus liquidity in the financial system could make economic overheating worse this year.
The Solution Is to Suppress Speculation
1) Loose US monetary policy and 2) market expectations of Chinese revaluation drive capital flow into China. Unless one or both of these conditions breaks down, China will continue to face excess liquidity. China cannot influence US monetary policy, but it can deal with the speculation surrounding its own economy.
The easiest solution, in our view, is to remove uncertainty in China’s exchange rate policy. To put an end to speculation, China should announce that it will not change currency policy for five years. Instead, it should focus on financial reforms that would make it possible to float the currency.
The reality is, in our view, that China could not touch the exchange rate for a long time. The economy is already sitting on a big bubble. A change in the currency policy could be very destabilizing. Making this transparent helps to cool down the economy, while leaving it vague makes the overheating worse.
As long as the currency policy leaves room for revaluation expectations, property speculation is, in our view, likely to continue. This property speculation could lead to a financial catastrophe. If the situation is left unchecked, it could cause political instability in the event that the bubble bursts.
If China cannot make currency policy transparent, it should at least stop property speculation. This would be quite easy, in our view. China can and should impose an 80% tax on capital gains for property flipping — selling within one year of acquisition. The tax rate could go down by ten percentage points for every additional year of holding on to the property.
Speculative hoarding is now a major force in pumping up property prices. Should the property bubble burst, the banking system could suffer enormously.
If China takes action to stop property speculation now, it could limit the future damage to the banking system and help average people buy properties at affordable prices. Such a solution would, in our view, be good for both financial and social stability.
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