Moving The System Into Reverse

China's monetary and development policy has been unchanged for many years. Reserve assets are accumulated, which fuels expansionary monetary policy, which fuels asset price increases, which attracts hot money that adds to reserve accumulation. Local government led investment is fueled by land sales, which fuels more real estate development and higher land prices.

Now that is changing. Reforms over the next 5 to 10 years, if successful, will guarantee that China doesn't work this way anymore. That's a good thing in the long-run, but the odds that nothing goes wrong is unlikely. It would be great if that were the case, but I wouldn't bet on it. People are accustomed to things working in a certain way and when it changes, it takes time for people to adjust. If they all adjust at the same time, it results in a volatile change in the market.

As Zhang Mo Nan says in the article below, bursting asset bubbles often complete the transition process— and even if they don't complete the process, they advance the ball a long way. This is why governments that do not intervene in market panics see their economies experience V shaped recessions: the transition is rapid. Governments that prevent rebalancing see L shaped depressions because they fight the market and preserve the dysfunctional system that led to the crisis in the first place.

China is already on the path to reform. The leadership is moving slowly because they don't want a disorderly transition. They want the growth from new markets to offset the slowdown in old markets, but there is a crisis of any size, it will accelerate reform, not derail it— assuming the leadership has consolidated power and squelched opposition.

张茉楠:货币扩张环境发生趋势性改变 Zhang Mo Nan: Monetary Expansion Trend Changing

Our money creation mechanism may be changing, future monetary policy is not only possible to enter "when fine-tuning" may also be necessary to make an inventory of the stock and currency adjustments. All along, China's monetary creation depends on the external surplus. In an open economy, foreign exchange reserves and the movements is not only a link between a country's domestic and foreign financial policies, but also reflects an important factor in the effectiveness of monetary policy and constraints. Caused by rising foreign exchange reserves will change the delivery of base money, enhance endogenous money supply.

From the central bank balance sheet perspective, the main asset is the central bank's foreign exchange reserves, IMF latest data show that the central bank's total assets up 31.7 trillion yuan (U.S. $ 5.1 trillion), of which the proportion of foreign currency reserve assets of the People's Bank's total assets at 83 %, respectively, 1.3 times the United States, Britain, Japan and the European Central Bank assets, 8.1-fold, 2-fold and 1.2-fold. From In this sense, the process is essentially the foreign exchange reserves increased by the People's Bank assets increased and the increase in base money in the process, which also led to foreign exchange earnings generated by external money creation to become the main channel.

However, two-way fluctuations in the RMB exchange rate, balanced two-way capital flows will become the norm, under the capital account deficit may occur in the background, based on the currency exchange rate mechanism will be put in a fundamental change, which is a traditional central bank money creation mechanism will be a new challenge. This year, the devaluation trend is more obvious, according to a report the Bank for International Settlements (BIS) released the latest, March RMB real effective exchange rate (REER), decreased 2.7% to 117.45, for the second consecutive monthly decline, a record in October 2013 Since the lowest level. Nominal effective exchange rate index for March was 112.64, also hit its lowest level since October last year, a decline of 1.8%. In mid-February to mid-March month, the RMB against the U.S. dollar fell 2.6%.

More and more facts indicate that the expansion of RMB assets and monetary trends in the internal and external environment is undergoing changes. According to estimates, currently with the U.S. interest rate, the forward exchange rate of RMB spot estimates of risk-free arbitrage narrowed significantly, foreign exchange continued to decline. February new foreign exchange from financial institutions of 437.366 billion yuan in January plunged to 128.246 billion yuan, a decrease of approximately 71% qoq, the highest since September last year lows. By FX channel functions are transformed into water leakage function. Particularly in light of the Fed's global "central bank" status, the Fed gradually withdraw monetary policy changes will affect the changes triggered by QE, including China, the global monetary and financial cycle.

On the one hand, due to the increase in the private sector to buy foreign assets, the central bank passively withdraw RMB liquidity, resulting in some degree of monetary tightening; the other hand, once formed devaluation expectations, reducing the non-governmental sector increased by U.S. $ RMB assets in the domestic asset allocation is Monetary assets to increase performance and reduce the risk of asset allocation, therefore, increased demand for liquidity, foreign exchange as a mechanism for the creation of base money will be weakened.

From a longer period, the growth rate of China's currency will inevitably stepped decline. First, determine the growth rate of the money supply is the most fundamental factor of economic growth, economic growth declined, the money supply growth rate will decline. Conditions of sustained high growth, long-term structural factors and macroeconomic situation is undergoing major changes, the future potential growth hub down, the appreciation of the RMB-way track changes and external liquidity pressure drop will be a long-term trend, coupled with the risk facing long-term decline in the valuation of assets and to bubble pressure stage of monetary expansion is also facing an inflection point.

Secondly, from a global rebalancing of the environment, the U.S. economy, "and then industrialization" and "rebalancing" may appear stronger than anticipated positive factors. U.S. aims to "to enhance the real economy can trade level" rebalancing strategy will lead to its economy increasingly clear long-term rate of return is expected to rise, while attracting global capital return to the U.S., or will gradually change over the past decade global capital the direction of flow.

Based on the above consideration of many factors, changes in foreign exchange could be a long-term change in the economic structure of a comprehensive reflection. Over the past decade, due to changes in the age structure of our population and the rural surplus labor to urban areas, rising savings rate, reflected in the balance of payments, the performance of the trade surplus continues to expand; reflected in the monetary environment is the rapid growth of foreign exchange , resulting in a lot of pressure of monetary expansion, and the future is likely to change this pattern.

All along, the high savings rate means faster asset or wealth accumulation, the rapid growth of wealth and rapid growth also requires liquid assets, money is the main form of liquid assets. However, the future with the acceleration of the process of population aging, high domestic savings will have a fundamental change in the situation, which will make the original "savings - surplus - monetary expansion," the cycle is reversed, the source of monetary expansion, which led to the disappearance.

Long period of evolution of the monetary and financial policy makers biggest implication is that to avoid asset bubbles out of control, strengthen financial stability mechanisms and measures. From the world experience, several major monetary and financial cycles are based on asset bubble burst, even in the form of the financial crisis to complete the transition.

Thus, with the trend of the future incremental foreign exchange decreased, the situation as the main channel of money creation will change occurs, the central bank deposit rate by reducing the need to enhance the money multiplier, which also means more money creation will depend on domestic credit growth, and was originally used to "sterilize" the foreign exchange deposit reserve ratio is likely to be money "anti-sterilize" the primary way in the coming period to improve M2 through this way. In addition, you can adjust the commercial banks and financial institutions excess reserves and the excess reserve rate impact of interest rate and liquidity, either through bonds or bond market, create a "bond pool" to hedge against the risk of falling water "currency pool."

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