China needs more inflation to save its economy - monetary policy can't do it alone

State-owned bank economist fires broadside at Modern Monetary Theory

A leading Chinese economist says looser monetary policy on its own is unlikely to save China from its current economic woes.

He says monetary policy only has a limited ability to achieve the rise in inflation needed to reduce real borrowing costs and restore confidence amongst Chinese businesses and households, arguing for fiscal policy to play a greater role.

China's central bank steps up to the plate in June

Since June of this year, the People's Bank of China (PBOC) - which is the Chinese central bank - has maintained a "supportive monetary policy stance," amidst faltering growth and an ailing property market.

Zhang Tao (张涛), chief economist at the financial markets department of China Construction Bank (CCB) writes that PBOC has since adopted measures including expanded money creation and the use of structured monetary policy tools.

PBOC's "supportive stance" further increased towards the end of September, with the supplementary introduction of a "raft of long-term policies" and a modest rate cut.

These included a 0.5 percentage point cut to the required reserve ratio for China's depository institutions - a move PBOC said could unleash 1 trillion yuan in long-term liquidity, as well as a 0.2 percentage point cut to the central bank's short-term policy rate (the rate on its 7-day reverse repos) from 1.70% to 1.50%.

PBOC's extended largesse arrived in tandem with Beijing's unveiling of plans for greater fiscal stimulus to bolster the economy, in a move which gave a sharp boost to China's stock market.

Macroeconomic measures achieve mixed success

Zhang Tao says the monetary and fiscal measures unveiled by Beijing at the end of September may have already helped to achieve a partial reheating of the economy.

Growth in social retail sales - comprised primarily of commercial goods - has just accelerated for the first time this year - rising from 3.3% to 3.5% in October.

The employment market also showed some improvement, with the manufacturing and services sector employment outlook index rising 0.65 points to 47.1.

Core CPI - in Zhang's opinion a key measure of average wage levels - saw YoY growth rise from 0.1% to 0.2%.

Year-on-year (YoY) growth in services retail consumption declining, however, falling to 6.5%.

Zhang argues that these changes in macroeconomic data indicate that "the economy is showing signs of rewarming due to policy support, but any 'heating up' has been limited."

Monetary growth dependent on government spending

Official data points to some improvement in China's monetary and credit metrics, with M2 money supply growth rising above the 7% threshold to 7.5%.

Once again, however, Zhang Tao points to only limited success of China's most recent monetary policy adjustments in this area.

M1 money supply growth - considered representative of enterprise funding - may have seen improvement, but still remains firmly in negative territory, with October seeing its decline contracting from -7.4% to -6.1%.

In October, the demand deposits of Chinese enterprises saw an annualised fall of -5.2 trillion yuan, for the 17th consecutive month of decline.

At the same time, enterprise fixed-term deposits saw an annualised increase of 2.8 trillion, a rise which Zhang considers a sign of limited confidence on the part of Chinese businesses.

Household demand and fixed-term deposits have held steady in terms of annualised growth, indicating no increase in economic activity on the part of everyday Chinese.

Zhang points out that these figures indicate any growth in financing has been dependent upon government borrowing and spending, with enterprise and household activity still in the doldrums.

"Non-government aggregate social financing continues to decline, from 25 trillion yuan for the same period last year to 21 trillion yuan," Zhang writes.

"Aggregate financing demand can only depend on the government sector."

In October, the government sector's annualised borrowing exceeded 10 trillion yuan for the fourth consecutive month, with the Chinese central government playing an especially prominent role.

China's central government currently accounts for nearly half of annualised government financing (5.2 trillion yuan), as compared to 3.6 trillion yuan out of a total of 8.6 trillion yuan for the same period last year.

China needs to boost inflation to reduce borrowing costs

Assuming a hawkish deficit stance and firing a broadside at Modern Monetary Theory (MMT), Zhang says this situation of dependence on government spending cannot persist indefinitely.

"According to MMT theory, the central bank's mission is very simple - it just needs to support central government financing," Zhang writes.

"However, there are many marked defects with MMT...for the central bank, it's hard to make guaranteeing of central bank financing the basis for its 'supportive monetary policy stance.'"

For this reason, Zhang believes China's policymakers need to focus on "continuing to restore the economic activity of enterprises and households."

In this regard, PBOC's use of "targeted" or structured monetary policy tools could prove critical, by directing lending to specific parts of the economy.

"The toehold of monetary policy should place greater emphasis on enterprises," Zhang writes.

This strategy, however, could also cause problems for China's financial system, given low deposit rates and the weak profitability of the country's commercial banks.

"Further reducing the financing costs of enterprises is already hampered by the extremely low net interest margins of commercial banks," Zhang said - referring to the difference between what banks charge for loans and what they spend for funding.

For this reason, Zhang considers an increase in inflation highly desirable, as it would give policymakers greater room to reduce borrowing costs.

"Further declines in nominal interest rates are very difficult, and right now if we want to reduce the burden on enterprises, this can only be achieved by reducing their real financing costs.

"This, however, depends on whether inflation rises."

Zhang believes, however, that monetary policy only has a limited ability to boost Chinese inflation.

For this reason, he advocates the use of fiscal policy as a tool for driving greater consumption, in order to boost prices and achieve the desired reduction in the real cost of borrowing.

"The experiences of many developed countries already prove that it's difficult for increases in monetary supply to escape from deflationary trap.

"It's end consumption that influences prices the most, so the focus of the central bank's supportive stance should be on improving the consumption expectations of households.

"At present, the most effective means of improving household consumer expectations is fiscal policy...this involves the use of over 10 trillion yuan in government financing, and how much it can improve the income expectations of households."