How Loose?

China's spending decisions and relaxed monetary policy have been cited as reasons for China's faster-than-expected economic improvement, alongside soaring credit and money supply. The lending momentum was obvious in June, when banks wrote 1.53 trillion yuan in new loans, contributing to the record 7.37 trillion yuan in loans for the first half -- 2.3 times the amount loaned during the same period last year.

The depth of this year's credit pool has surprised many. Even the central bank failed to anticipate such a huge boom. Actually, a central bank official who asked to remain anonymous told Caijing in early June that total new credit for all of 2009 should be held at 8 trillion yuan – a goal that's now obviously impossible.

High levels of fiscal investment and credit have become economic stimulus tools for China. As these steps emerged, officials started using the expression "relatively relaxed" for the first time to describe government monetary policy. Some have wondered whether "excessively loose" may be a better way to describe the current policy.

In June, the nation's money supply (M2) grew 28.5 percent year-on-year to its highest level since the central bank started disclosing M2 data in 1997. According to financial data provider Wind Information, the central bank released 275.5 billion yuan through the open market during the first half of 2009.

An official at a state-owned bank expressed surprise at the central bank's decision to issue notes, which he said reduced market liquidity somewhat and signaled a mild adjustment in government policy.

Another policy adjustment came June 30, when the central bank snapped a half-year-old policy that kept interest rates low. The bank raised the 28-day repo rate to 0.95 percent from 0.90 percent.

On July 14, the central bank drained 150 billion yuan from the money market via 28-day repos and 91-day repos, increasing the repo rates by another 5 basic points. That same day, the central bank took a more direct approach by issuing to selected banks 1-year notes worth 100 billion yuan, with buyers asked to make payments in mid-September.

Then on July 15, the central bank announced another notes program for "no less than" 20 billion yuan, changing its tone slightly by replacing the issue level's description from "up to" a certain amount to "no less than."

A knowledgeable source said the notes program was designed to control bank lending in the third quarter. "Selected" banks chosen to participate were mainly those that reported lending spikes toward the end of the second quarter, including state-owned and joint-stock banks.

Because the central bank did not change its 1.5 rate for these new notes, some industry insiders said the bank's move may have been designed to simply absorb excess liquidity. However, market players think the government notes will have limited impact, since banks have already issued credit amounts that dwarf the notes program.

Ma Jun, Deutsche Bank's chief China economist, said "mild" policy initiatives including the issuance of central bank notes, as well as window and risk guidance, cannot effectively halt the rising tide of growing market liquidity.

Essence's Gao argued that the central bank cannot be expected to overhaul monetary policy as long as the highest level decision-makers in China set basic economic conditions. For that reason, the central bank's action is more about risk warnings than absorbing liquidity from the market.

However, Gao said the warnings should be taken seriously. "China's banking regulators should be doing more in the areas of risk prevention and risk control," he said.

Down Investment Trail

Investment is no doubt the most powerful of three engines – the others being exports and domestic consumption – driving China's economic growth.

New investment contributed 6.2 percent to the nation's 7.1 percent GDP growth recorded in the first half 2009. Consumption added 3.8 percent, while net exports contributed a negative 2.9 percent.

Fixed-asset investment grew 35 percent in June while real growth rose nearly 30 percent, after factoring in a decline in consumer prices, setting an historical high. Overall, fixed-asset investment represented 65 percent of the country's economic growth by the end of second quarter.

Ha said new project investments nearly doubled – a sign that future investment growth may climb even higher.

Investment financing at local government levels has mainly come through bank loans. And most of these investment projects involve infrastructure, which means follow-up investments will be necessary. Some say this underscores the need for maintaining a relaxed monetary policy. On the other hand Shen Minggao, Caijing's chief economist, worries that local investments may stand in the way of monetary policy adjustment.

China's foreign trade sector is now hoping to secure its current market share. But even as the global economy improves, and China's export contraction slows, it's not yet foreseeable that exports will turn around and again contribute to GDP growth.

Domestic consumption in China, at least in the short term, can hardly be expected to become a greater economic driver. Although retail consumption climbed 16 percent in the first half of this year compared to the same period 2008, the National Statistics Bureau said average personal income remained flat in the second quarter, indicating a leveling of personal spending growth in the future.

Investors and policymakers are now weighing the evidence to determine whether China's investment-driven economic growth is sustainable. And if it can be sustained, how long the ride will last?

Actually, China's current economic policy is similar to what was adopted in the United States in late 2001, after the 9/11 attacks. The then-chairman of the Federal Reserve, Alan Greenspan, managed a rather relaxed monetary policy that kept the federal funds rate at historical lows, leading to a flood of liquidity worldwide.
 
Since western countries have no effective means to prevent asset bubbles, the subprime mortgage crisis erupted, leading to a financial storm that dragged down the world economy.

Martin Feldstein, a Harvard University economics professor who served in Greenspan's time at the National Bureau of Economic Research, told Caijng that an assets bubble is harder to treat than inflation and can do more damage.

1 yuan = 14 U.S. cents

Full article in Chinese: http://magazine.caijing.com.cn/2009/cjfm242/