SERIOUS MONEY:THE STUDY of economic history is a valuable pursuit. Unfortunately, all too often the questionable verdicts of respected academics have been seized upon by populists,and regurgitated as accepted fact in best-selling books launched on an unsuspecting public.
The search for an economic model that promises nirvana has seen the naive believe in the 1950s that the Soviet Union’s command economy would overtake the mighty United States – a belief that was reinforced by the launch of sputnik, the worlds first satellite, in 1957. The supposed triumph of communism received further support four years later as Yuri Gagarin became the first man in space, only for the supposedly superior economic model to come apart at the seams four decades later.
Long before the Soviet model came unstuck, populist eyes had turned to Japan and deemed its quasi-socialist export model as the path to long-term prosperity. The claims proved unfounded as the dual bubbles in property and stocks imploded in the late-1980s.
More than two decades later, the Land of the Rising Sun is still struggling to move forward from the resulting economic carnage.
The Japanese demise saw would-be authors look to southeast Asia for inspiration, but that particular economic miracle – grounded as it was in crony capitalism – fell by the wayside in the late-1990s, a development that saw opinion shift full-circle and deem the United States as the only economic superpower.
Unfortunately, such grandiose opinions proved false as the frailties of the US were exposed for all to see, once a seemingly innocuous housing problem morphed into a full-fledged crisis that brought the world’s financial system to its knees.
Another page in economic history has been turned and populist texts now focus on the Chinese model of state-directed capitalism as the preferred route to prosperity.
It is beyond dispute that the reforms enacted in the Middle Kingdom in the late-1970s by then-premier Deng Xiaoping and the subsequent near double-digit growth over three decades has lifted millions out of poverty. But to claim the superiority of the Chinese model is questionable, given the low starting base.
Developments in the months ahead will put the argument to the test as the authorities grapple with a disturbing increase in inflation just as bad loans – made as a result of the aggressive stimulus undertaken at the height of the global financial crisis – begin to surface.
Premier Wen Jiabao noted recently that inflation was a “tiger” that, once freed, would be difficult to put back in its cage. The inflation rate hit a 34-month high of 5½ per cent in May, despite aggressive efforts to keep a lid on prices, and it is now all but certain that the official target of 4 per cent for the full calendar year will not be met.
Consumer price inflation has jumped by more than three percentage points from its cycle low of less than 2 per cent in late-2009 and looks set to exceed 6 per cent in June. But, unlike the previous experience of inflation when disruptions in the food supply chain – primarily blue-ear disease and the resulting surge in pork prices – were the primary culprit behind the uptick in inflation, the acceleration in consumer price increases this time is broad-based and evident in food and non-food items.
The People’s Bank of China has raised interest rates four times since October, but the central bank remains well behind the curve with deposit rates still in negative territory in real terms. Real lending rates of little more than 1 per cent can hardly be described as restrictive.
The monetary authority’s ability to tighten policy aggressively is restricted due to its quasi-fixed exchange rate vis-a-vis the dollar, which means interest rates cannot be raised to appropriate levels without attracting large capital inflows that accelerate growth in the money supply.
For this reason, the central bank has used banking sector reserve requirements as its primary tool to absorb excess liquidity. The reserve requirement ratio has been lifted six times since the start of the year to an historical high of 21½ and 19½ per cent for large and small banks respectively. More is required but the room to manoeuvre is small given that negative real rates are driving funds out of the banking system and tight liquidity conditions are already apparent in money market rates.
The urgent need for higher interest rates comes just as the scale of bad loans made by local governments at the height of the financial crisis is becoming apparent. China’s central government recently announced that it will take responsibility for as much as three trillion renminbi in at-risk loans extended by Chinese banks to local government financing vehicles. The amount is equivalent to more than 7 per cent of GDP and may only be the tip of the iceberg, as initial estimates of ultimate costs in such situations tend to be best-case and often fall well short of the eventual outcome.
Furthermore, problems are sure to surface in other loan categories should the authorities take the necessary steps to quell inflation.
Does China really possess a superior economic model as argued by some populists? Time will tell, but it is doubtful.
charliefell.com
