Structured to Survive

By JOHN ROSS

Confronted with these dismal statistics, Western central banks have responded with a common policy of massive money creation. The U.S. Federal Reserve launched QE3 – a US $40 billion (RMB 250 billion) open-ended purchase of mortgage-backed securities, to be conducted monthly. The European Central Bank announced an unlimited program of Outright Monetary Transactions (OMT) – the creation of money to purchase European government bonds. The Japanese Central Bank intervened in an attempt to lower the yen’s exchange rate.

Such massive monetary injections affect the global economy and individual markets alike. Mohammed El-Erian, chief executive of PIMCO, the world’s largest bond investor, has cited one risk created by such a process. “Essentially the Fed is inserting a sizeable policy wedge between market values and underlying fundamentals... In the process, many asset prices are hovering near what would normally be regarded as bubble territory, with some already there,” El-Erian said.

Whether or not you agree with El-Erian’s analysis, one thing is certain: Western central banks are engaging in quantitative easing on a scale unprecedented in recent memory.

Central banks are resorting to drastic monetary policy to boost their economies because they have few options left in the policy toolbox. This brings us to one advantage of China’s economic structure: the country has more tools. As the Wall Street Journal correctly put it: “Most economies can pull two levers to bolster growth – fiscal and monetary. China has a third option... accelerate the flow of investment projects.”

Globally speaking, the major lingering feature of the financial crisis is low investment. In developed economies all other major components of GDP are now above pre-crisis levels. Fixed investment nevertheless remains US $491 billion below its peak in inflation adjusted terms. It is the inability to reverse this fall in investment that paralyzes developed economies.

In contrast, China’s 2008 stimulus program, and the more limited economic boost launched in the middle of this year, tackled the situation directly via state decisions on increasing investment. As many Western economies reject significant state investment on ideological grounds, they are forced to rely purely on budgetary consumption measures and monetary expansion.

When the financial crisis erupted in 2008 almost all Western economies responded by simultaneously introducing ultra-low interest rates and expanding budget deficits, the latter financed via borrowing. But the scale of the economic downturn made it clear that such large borrowing would have to continue for a long period of time. Running budget deficits that in some cases approached or exceeded double-digit percentages of GDP would therefore hugely increase state debt. The IMF’s latest World Economic Outlook rightly stressed that state debt in the U.S., Japan and many European countries is now around, or above, 100 percent of GDP.

At the IMF gathering, a sharp debate took place between those, led by Germany, who want rapid budget deficit cuts, and those, supported by IMF Managing Director Christine Lagarde, who regard slower deficit reduction as a less risky strategy. But no mainstream Western government proposed responding to the new global downturn with major new fiscal expansion. Therefore, it has come to pass that fiscal policy has been cast aside; monetary policy is the only politically acceptable available tool with which to fashion a response. And using this one tool to excess has consequences.

Monetary expansion has so far failed to halt the slowdown in Western economies and is actually creating structural financial problems. With prolonged periods of extremely low interest rates, and with money creation continuing on such a large scale, financial decisions are distorted. And distortions lead to bubbles, which more often than not collapse when interest rates are eventually brought back to historically average levels.

How does this affect China? One immediate risk is inflation. Even before QE3 was officially announced, media speculation preceding it precipitated a sharp increase in global commodity prices. The Dow Jones-UBS index of spot commodity prices rose by 18 percent between June and October, with even more rapid increases in key food prices following the additional impact of drought in the U.S. The resulting food price rises stimulated social unrest in the Middle East, South Africa and India. As China’s CPI follows world commodity prices, China’s economic policy must guard against inflationary risks.

However upward pressure on global commodity prices created by QE3 is countered by downward pressure due to the world economic slowdown. Global commodity prices remain nine percent below the level reached in early 2011, when they propelled China’s CPI to 6.5 percent in July of that year. China is limited in the type of expansionary policies it can pursue due to the fact that it must exercise caution. So far, however, the international situation does not indicate that inflation in China is likely to become an intractable problem.

The large quantitative easing programs being conducted by the U.S., ECB and Japan pose other threats. Parts of the monetary expansion will inevitably spill into other economies, including potentially China’s, a process that threatens to create asset bubbles. For this reason leading international monetary experts, such as Barry Eichengreen, have advised countries to strengthen administrative currency controls.

Given this situation, China’s central bank has rightly been cautious with regards to loosening monetary policy. Rather than making further reductions in interest rates, or cuts in reserve requirements, since July it has preferred to deal with domestic liquidity issues by short term monetary injections that can be reversed relatively rapidly.

Given the downward pressures from the world economy, China clearly must boost domestic demand. However, the Western Central Bank policies already described mean that this must mainly be done by directly stimulating China’s productive economy rather than by generalized monetary infusions. The key question hence becomes: How should such a stimulus be divided between investment and consumption?

China’s former World Bank chief economist Justin Yifu Lin has rightly argued that for long-term economic reasons an economic stimulus is better delivered via boosting investment rather than consumption. The same conclusion follows from trends already described in the business cycle since the financial crisis hit. Nevertheless, China has significantly increased its percentage of investment in GDP since 2008 and practical management factors must be taken into account – it is difficult to deliver very large increases in investment efficiently. For that reason, China’s recent economic policy moves to moderately boost both consumption and investment are appropriate. Investment increases were included in measures adopted in the summer. Steps to boost consumption were taken, for example, by abolishing road tolls during China’s recent Golden Week holiday – a measure designed to encourage tourism.

Sharp easing of monetary policy by Western Central Banks is unlikely to lead to significant growth in their economies, since they fail to deal with the underlying problem of falling investment. They will, however, create problems for other players in the world economy. No country, including China, can escape all the problems resultant from the travails of struggling Western economies. But the structural superiority of China’s socialist market economy over Western free market ones means that, as has been the case since 2008, China will continue to ride through periods of economic turbulence far more successfully than other major countries.