Challenges for Monetary Policy in China:

Stodder: Monetary Pollicy, JulyStodder: Monetary Pollicy, July 11

Challenges for Challenges for Monetary Policy in China:Monetary Policy in China:

I. Overheating and Financial Depth,

II. Adverse Selection and Credit Rating Error,

III. Macro-economic Stability and Loan-Loss-Reserve Regulation


I. OverheatingI. Overheating

1.1. Evidence of OverheatingEvidence of Overheating

2.2. Inefficient Capital AllocationInefficient Capital Allocation

3.3. Informal Financial IntermediariesInformal Financial Intermediaries

4.4. Excessive Money SupplyExcessive Money Supply

5.5. Small Government Bond MarketSmall Government Bond Market


1. Evidence of Overheating: 1. Evidence of Overheating: Inflation SpikeInflation Spike

Consumer Price Inflation in China

-0.8

1.2

4.1

1.81.5

4.4

-1

0

1

2

3

4

5

2002 2003 2004 2005 2006 2007

An

nu

al %

Ch

an

ge

CPI

Source: CIA Factbook, and June 2007 Figures


Evidence: Evidence: Real Estate PricesReal Estate Prices


Evidence: Shanghai Evidence: Shanghai Engineers’Engineers’ Salaries Salaries HigherHigher than in Thailand, Indonesia, than in Thailand, Indonesia, PhilippinesPhilippines

Source: METI - China and ASEAN4


2. Capital Allocation: 2. Capital Allocation: State BanksState Banks to State-Owned Enterprises to State-Owned Enterprises

Source: McKinsey


Capital Allocation: Capital Allocation: Too Too ScarceScarce in Inland Areas in Inland Areas

Source: METI


Capital Allocation: Capital Allocation: Can Can Heighten Regional InequalitiesHeighten Regional Inequalities

Source: METI


3. Money Supply3. Money Supply: China’s M2/GDP out of : China’s M2/GDP out of proportionproportion Figures for

1999/2000

Country GDP per capita M2/GDP(%)

CHINA $2,001 150.0

Singapore $12,963 90.0

Korea, Rep. of $5,626 40.0

Malaysia $2,368 70.3

Thailand $1,466 69.5

Philippines $706 31.8

Indonesia $580 41.1

Sri Lanka $466 30.5

India $358 46.1

Pakistan $336 39.7

Bangladesh $200 31.3

http://www.allcountries.org/china_statistics/index.html


4. Informal Finance:4. Informal Finance:

“ “ All small businessAll small business start with start with loans from family and friends. loans from family and friends. I’m not aware of I’m not aware of anyany business business that was that was startedstarted with bank with bank financing.”financing.”

- Manager of one of Shanghai’s 10 largest - Manager of one of Shanghai’s 10 largest Private Firms (McKinsey)Private Firms (McKinsey)


Informal Financial IntermediariesInformal Financial Intermediaries

Source: McKinsey

$101

$838

$2,412

0%

20%

40%

60%

80%

100%

Distribution of Banking Deposits (2004), in Billions of Dollars

Corporate andother BankDeposits

Lending fromFamily andFriends

UndergroundBank Loans

28%


5. Small Government Bond Market: 5. Small Government Bond Market: Makes Central Bank’s Job Makes Central Bank’s Job More More DifficultDifficult

Source: McKinsey


II. Adverse Selection by

Credit Rating Error Think of two firms which must go Think of two firms which must go

through a long difficult process – through a long difficult process – just to achieve the just to achieve the samesame credit credit rating.rating.

But say the 1But say the 1stst firm is a firm is a goodgood risk, risk, while the 2while the 2ndnd firm is a firm is a poorpoor risk. risk. (So there is (So there is Rating ErrorRating Error.).)

Which firm will be Which firm will be more determinedmore determined to complete the rating process?to complete the rating process?


Empirically Based Empirically Based Simulation of Credit Rating Simulation of Credit Rating Effects:Effects: ““Modeling the economic value of credit Modeling the economic value of credit

rating systems”, by Jankowitscha, rating systems”, by Jankowitscha, Pichlera, and SchwaigerbPichlera, and Schwaigerb

Journal of Banking & Finance Volume 31, Issue 1, January 2007, Pages 181-198


Adverse Selection: Adverse Selection: History of History of 30,000 Austrian Corporate 30,000 Austrian Corporate LoansLoans

Source: Jankowitsch et. al., Journal of Banking & Finance (2007)


Adverse Selection: Adverse Selection: Basis Point Basis Point Improvement in Change from Improvement in Change from LowLow Credit Credit Rating AccuracyRating Accuracy

Portfolio Quality

Δ low to medium

Δ low to high

Δ low to perfect

Good 30.8 43.7 44.8

Average 32.6 45.9 46.8

Weak 39.0 56.4 58.7 Source: Jankowitsch et. al. (2007)


Adverse Selection

The study finds this improvement in The study finds this improvement in return is mostly due to return is mostly due to less adverse less adverse selectionselection – not – not better loan pricingbetter loan pricing..

As a very distinguished banker friend As a very distinguished banker friend of mine once said:of mine once said:

““If you lose the principle, it’s hard to If you lose the principle, it’s hard to make it up on interest payments.”make it up on interest payments.”


III. Macro-economic Stability and Loan-Loss-Reserve Regulation ““A sound banker, alas, is not one A sound banker, alas, is not one

who foresees danger and avoids who foresees danger and avoids it, but one who, when he is it, but one who, when he is ruined, is ruined, is ruined in a ruined in a conventional way,conventional way, along with along with his fellows,his fellows, so that no one can so that no one can really blame him.”really blame him.”

– J.M. Keynes (1931)J.M. Keynes (1931)


Macro Stability: Keynes noted the “Paradox of

Thrift”

Consumers cut back on their spending Consumers cut back on their spending and and save more during a recessionsave more during a recession. . This only This only makes the recession worsemakes the recession worse..

Similarly, Similarly, Loan Loss Reserves (LLR)Loan Loss Reserves (LLR) are often are often raised in a recessionraised in a recession, just , just when banks can least afford them – when banks can least afford them – often ensuring their collapse and often ensuring their collapse and worsening the recessionworsening the recession..


Macro Stability: Perverse Loan-Loss

Regulation Laeven, Luc & Majnoni, Giovanni, Laeven, Luc & Majnoni, Giovanni,

2003. 2003. "Loan loss provisioning and "Loan loss provisioning and economic slowdowns: too much, economic slowdowns: too much, too late?,"too late?," Journal of Financial Journal of Financial IntermediationIntermediation,, Vol. 12(2), April, pages Vol. 12(2), April, pages 178-197.178-197.

Can be downloaded from World Bank:Can be downloaded from World Bank:http://ideas.repec.org/p/wbk/wbrwps/2749.html


They argue that LLR should be ‘pro-cyclical’, built up in good times, so that it is available for bad times.


Instead, LLR growth ‘counter-cyclical’:Weak LLR in booms spurs inflation, Strong LLR in busts worsens recessionsDependent Variable: LLR %

Europe U.S. JapanLatin

America ASIAEarnings (EBT)/Assets ***.209 ***.207 ***.545 ***.280 *.053

Negative earnings (?)* ***-.373 ***-.541 ***-1.329 ***-.444 ***-.590

Loan growth ***-.008 ***-.006 ***-.016 ***-.009 ***-.010

GDP growth ***-.070 ***-.160 ***-.148 0 ***-.091

R-squared 0.15 0.32 0.48 0.24 0.30

Bank-year observations 2,477 2,288 1,016 570 951

No of banks 438 388 145 126 166

(***: p-val < 1%, **: p-val < 5%, *: p-val < 10%)


Tentative Conclusions:Tentative Conclusions:

China’s Monetary Policy challenge is China’s Monetary Policy challenge is very difficult, with very difficult, with few policy few policy instrumentsinstruments

A good Credit Rating System has great A good Credit Rating System has great potential for potential for improved financial returnsimproved financial returns from bankingfrom banking

However, However, poor regulationpoor regulation based on based on credit rating has the potential to credit rating has the potential to increase macro-economic instabilityincrease macro-economic instability

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Challenges for Monetary Policy in China: