The liquidity crunch in China's banking system reflects the changing direction of hot money. It has happened before. The difference now is that, after nearly six years of unprecedented easing policy, the US Federal Reserve is expected to reverse course before long.
China has been sustaining a monetary bubble since 2004. After joining the World Trade Organisation, it gained a market share in global trade. This one-time increase in productivity should have been reflected by a one-time jump in the exchange rate. But China chose to appreciate its currency gradually to minimise the impact on the export sector. This served to attract the massive inflow of hot money and bottled up all the local money at home. It was the main factor that led to a nationwide property bubble.
When the US credit bubble burst in 2008, it should have triggered a similar adjustment in China, as exports declined. But China chose to support the bubble by force-feeding the property sector with massive amounts of easy credit. The trust industry, now with more than 9 trillion yuan (HK$11.3 trillion) in assets, is a result of the credit binge. The stimulus policy in 2008 further inflated the bubble. China's financial system is now in a precarious shape. The trust industry is little more than a Ponzi scheme for land speculation.
Within China's political system, there is a powerful force to keep asset prices inflated. Political power reigns over market forces in China, which is what a socialist market economy with Chinese characteristics is all about. Besides, political power can be monetised through asset inflation; someone with power can borrow to buy assets and push for monetary inflation to profit from rising asset prices. When the bubble becomes big, the vested interests become more powerful.
This is why China's efforts to rein in monetary expansion since 2004 have all been short lived, validating market belief that the government would not dare prick the bubble. Hence, more and more money is now used to sustain the bubble. The consequence is that monetary growth does not affect the real economy any more.
Few expect the current round of liquidity tightening to last. Market players may hang back for three to four months, before getting back in. If the consensus is correct, China could be heading for a collapse à la Indonesia in 1998.
For example, the central bank can run down the foreign exchange reserves to replenish the lost liquidity. But China's M2 broad money measure is six times the forex reserves in size, and the former's annual increase is two-thirds the latter's.
When the market senses the central bank is subsidising capital flight, everyone will have an incentive to run for the exit. A collapse may follow.
Controlling the money supply is key to China's macrostability. As local governments and state-owned enterprises are the main borrowers, the interest rate does not influence demand that much. The private-sector demand is mainly from property developers, which hand the money to local governments through land purchases and taxes. They can mark up the land price to offset a rise in interest rates.
Hence, targeting only interest rates would lead to a massive increase in money demand. This is what happened in the last quarter of last year and the first half of this year.
Quantity control, say, by holding the growth of M2 to 13 per cent this year, could lead to extraordinarily high interest rates. But local governments do not care about the interest rate. To push down the rate, the central government will have to push back borrowing by local governments.
Reforming China's economy takes a long time. Without limiting the powers of local governments, any economic reform will merely be a propaganda exercise; local governments can always find ways to subvert it. The primary goal of the central government's policy should be to buy time for prolonged structural reforms.
This must be done by controlling money supply. It is the only way to limit corruption and waste.
In the months ahead, a chorus of opinion will surface in the media on the perils of "tight" liquidity. So many powerful people have invested in asset inflation that the pressure on any liquidity tightening would escalate with time. Their main argument against tightening will be that a collapse of the property market would lead to a collapse of the economy in general.
This is far from the truth. Any decline in construction will not affect social stability. China is facing a severe shortage of blue-collar labour. And China's exports and consumption are stable. A collapse of the property market would cut production costs and empower consumers. The economy would strengthen over time.
Holding down money supply now is probably the last chance for China to prevent an Indonesian-style collapse. Whatever the consequences from the liquidity tightening now, such as a collapse of the trust industry, they would be small compared to what could occur if the asset bubble is left alone. The bad debts that would result from a property market crash could be covered in five years. Chinese people, after all, are highly competitive in the global economy. But if the bubble is left to balloon, there will not be enough people in China to cover the losses.
The elite of Kuomintang loved money more than power. Before 1949, they increased money supply in any way possible to bail themselves out of their speculative positions. They lost China. But they remained rich in Taiwan or America. The same test is facing the elite of the Communist Party today. Do they love money more than power?
Andy Xie is an independent economist