Saturday, October 24, 2009

Buiter on bubbles and China

Willem Buiter is a very smart and knowledgeable person; however his blog posts are always very (very!) long. No worries dear reader, I am here to select the good stuff for you (from: Beware asset market & credit booms bubbles & busts in emerging markets). I will also highlight a classic rookie mistake he made, much like I did in my previous post.
(...) the world is being flooded with official liquidity by the leading central banks of the overdeveloped world.
First remark: the expression "overdeveloped world" may be the best thing I've heard since "Goldilocks economy". It just explains so much in one single world... this is economic poetry! I don't know if Buiter originated it, it is the first time I see it. It continues:
Commercial banks either hoard the newly injected central bank liquidity at the central bank in the form of deposits or use it to purchase safe liquid assets, such as the sovereign debt instruments of reasonably solvent nation states. (...) Broad monetary aggregates are growing little if at all in the overdeveloped world and credit growth to the non-financial enterprise sector and to the household sector remains minuscule.  We are therefore unlikely to see a credit boom or asset market frenzy any time soon in the advanced industrial countries, let alone any pick-up in domestically generated inflation for indices like the CPI. The massive injection of official liquidity by the Fed, the ECB, the Bank of England, the Bank of Japan and other central banks in the north-Atlantic region is much more likely to show up as credit and asset market booms, bubbles and - eventually - busts in those emerging markets that are growing rapidly again, that is, most emerging markets other than those in Central and Eastern Europe.  China, Brazil, India, Indonesia, Singapore, Turkey and Peru are but some of the countries at risk. (...) The reason for this liquidity spill-over is the desire of many of the rapidly expanding emerging markets to prevent a large real appreciation of their currencies vis-à-vis those of the cyclically lagging advanced industrial countries. (...) The accumulation of foreign exchange reserves that results is only partly sterilised. The result is externally financed expansion of the domestic money supply and more rapid domestic credit growth. This will leak at least partly into domestic asset markets, creating the conditions for boom, bubble and bust.
And now, on China:
China is especially at risk of booms and bubbles in its stock market, its residential housing market and its commercial and industrial property markets.  That is because the externally funded liquidity injection resulting from Chinese attempts to keep down the external value of the yuan are reinforced by further domestic credit expansion associated with the Chinese fiscal stimulus. (...) China is creating massive excess capacity in export-oriented industries (and indeed in some of the low-tech consumer goods where it no longer is the global low-cost producer).
(My emphasis). Continues:
In two or three years, when these loans will be going into default on a large scale, the central bank or the ministry of finance will recapitalise the banks, using a mixture of government debt, central bank domestic credit and foreign exchange reserves.
And there it is - the rookie mistake: recapitalising the Chinese banks with foreign exchange reserves. I've seen that countless times but I didn't expect Buiter to fall into that trap. Let me explain: you cannot use foreign exchange currency (in that case, mostly dollars) to recapitalise a domestic currency (yuan) balance sheet. Have you ever heard of a company having equity in foreign exchange currency ? It is just silly ! Now, what you could in theory do is convert this dollars in yuan, and use the proceeds to recapitalise the banks. But that would entail a large appreciation of the Chinese currency: remember, if the central bank just stopped buying dollars, the renmibi would most likely increase by 20% to 40% rappidly. What would happen then if the central bank started to sell dollars ? A very destabilizing overshoot in the exchange rate. Now, would you like to see that happen to your country, if at the same time your country's banking system is in need of being recapitalized ?

Let's continue with Buiter, who is otherwise right to the point:
The boost to domestic demand is overwhelmingly in the form of fixed investment, much of in the the wrong, old industries.  Without a miraculous recovery of export demand growth, excess capacity will re-emerge with a vengeance in the export industries.
(...) Other emerging markets too are likely to be faced with domestic asset market booms and bubbles, in particular the oil and gas exporting nations of the Gulf Cooperation Council (GCC).  These countries still peg to or shadow the US dollar quite closely, despite a number of attempts, through basket-pegging and similar manoeuvres, to loosen their ties to the US dollar. (...) The credit and asset market boom, bubble and bust I foresee for the rapidly growing emerging markets is not inevitable.  It is a policy choice.  If the emerging market countries in question are willing to let their currencies appreciate sufficiently against the US dollar and the currencies of the rest of the overdeveloped world, there will be no domestic monetary and credit expansion financed by imperfectly sterilized foreign reserve inflows. For China, preventing excessive credit growth and asset booms and bubbles is more difficult, as in addition to the external liquidity injection, the government is, through the banking system, injecting massive amounts of domestic liquidity into the economy.  This would become unnecessary if China were able to switch the composition of production and of domestic demand towards consumer goods and services and non-traded goods and services.


  1. "Now, what you could in theory do is convert this dollars in yuan, and use the proceeds to recapitalise the banks."

    Don't agree. Banks' balance sheets are scorecards of internal balances within China. To fix bad balance sheets the CB has a yuan printing machine.

    Internal balances within China have nothing to do with external balances (reserves) towards the rest of the world.


  2. Anonymous: yes, that is precisely the point I am trying to make...

  3. tracked you here from mpettis blog. good stuff.

    Would it be accurate to say that the PBOC's reserves are masking the exchange rate distortions in the pegged 6.8 to 1 rate they offer their exporters ?

    Or is the increase in US/Europe purchasing power from the peg being paid for in real-time by stripping the savings of the Chinese exporters?

    Any thoughts would be appreciated regarding the where the imbalances lurk on China's end.. but i understand you are no doubt busy

  4. I am not sure I understand your question... The massive increase in reserves is not "masking" anything, it is more simply a direct consequence of the peg: in order to keep the exchange rate constant in the face of massive currency inflows (due in large part to exports), the PBOC has to buy a equal amount of dollars. If the PBOC didn't accumulate as many dollars, the exchange rate would increase and the trade surplus would not be as large.