China stuck on currency treadmill

The scale of China's monetary expansion is unprecedented, writes Zhang Monan.

It is indisputable that China is over-issuing currency. But the reasons behind China's massive liquidity growth - and the most effective strategy for controlling it - are less obvious.

The last decade has been a "golden age" of high growth and low inflation in China. From 2003 to 2012, China's annual GDP growth averaged 10.5 per cent, while prices rose by only 3 per cent annually. But the unprecedented speed and scale of China's monetary expansion remain a concern, given it could still trigger high inflation and lead to asset-price bubbles, debt growth, and capital outflows.

Data from the People's Bank of China shows that, as of the end of last year, China's M2 (broad money supply) stood at 97.4 trillion yuan ($15.3 trillion), or 188 per cent of GDP. In the US, M2 amounts to about 63 per cent of GDP.

In fact, according to Standard Chartered Bank, China ranks first worldwide in terms of overall M2 and newly issued currency. In 2011, China accounted for about 52 per cent of the world's added liquidity.

But a horizontal comparison of absolute values is inadequate to assess the true scale of China's monetary emissions. Several other factors must be considered, including China's financial structure, financing model, savings rate, and stage of economic development, as well as the relationship between currency and finance in China.

China's intensive economic monetisation is a key factor driving its money-supply growth. But the sharply rising monetisation rate cannot be judged against the high, steady rates of developed countries without bearing in mind that China's monetisation process began much later, and has distinct structural and institutional foundations.

As China has opened up its economy, deepened reforms, and become increasingly market-oriented, the government has facilitated the continuous monetisation of resources - including natural resources, labour, capital, and technology - by ensuring their constant delivery to the market. This has fuelled rising demand for currency, leading to the expansion of the monetary base, with the money multiplier - that is, the effect on lending by commercial banks - boosting the money supply further.

And, as GDP growth has become increasingly dependent on government-led investment, currency demand has risen. Indeed, the rapid expansion of bank credit needed to finance skyrocketing government-led investment is increasing the amount of liquidity in the financial system.

This trend is exacerbated by the declining efficiency of financial resources in the state sector, a product of the soft budget constraint implied by easily accessible, cheap capital. Consequently, maintaining high GDP growth rates requires an ever-increasing volume of credit and a continuously growing money supply. So China is stuck in a currency-creating cycle: GDP growth encourages investment, which boosts demand for capital. This generates liquidity, which then stimulates GDP growth.

The key to controlling China's monetary expansion is to clarify the relationship between currency (the central bank) and finance (the financial sector), thereby preventing the government from assuming the role of a second currency-creating body. According to Pan Gongsheng, a deputy governor of the PBOC, the relationship between the central bank and the financial sector entails a division of labour and a system of checks and balances. In theory, the financial sector serves as a kind of accountant for the treasury and the government, while the PBOC acts as the government's cashier.

In practice, however, the relationship between currency and finance is vague, with both assuming quasi-fiscal functions. China's low official government debt largely reflects the role of currency in assuming quasi-fiscal liabilities - not only the write-off costs incurred from reforming state-owned banks, but also the takeover of banks' bad debts via note financing and the purchase of asset-management companies' bonds. These activities damage the PBOC's balance sheet and constrain monetary policy.

Finance takes on quasi-fiscal functions by excluding government fiscal deposits - deposits in the national treasury, commercial banks' fiscal savings, and central treasury cash managed through commercial bank deposits - from the money supply. Given the large volume of fiscal deposits, their impact on the money supply cannot be ignored.

Clarifying the relationship between currency and finance is essential to ensuring that all newly issued currency is backed by assets. Only by exerting a harder budget constraint on the state sector, limiting fiscal expansion and reducing dependence on government-led investment can China's excessive currency issuance be tackled in the long term.

Zhang Monan is a fellow of the China Information Centre, a fellow of the China Foundation for International Studies, and a researcher at the China Macro-economic Research Platform.