MonetaryPolicyInChina

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Challenges for Monetary Policy in China:: 

Challenges for 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. Overheating: 

I. Overheating Evidence of Overheating Inefficient Capital Allocation Informal Financial Intermediaries Excessive Money Supply Small Government Bond Market

1. Evidence of Overheating: Inflation Spike: 

1. Evidence of Overheating: Inflation Spike Source: CIA Factbook, and June 2007 Figures

Slide4: 

Evidence: Real Estate Prices

Slide5: 

Evidence: Shanghai Engineers’ Salaries Higher than in Thailand, Indonesia, Philippines Source: METI - China and ASEAN4

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

2. Capital Allocation: State Banks to State-Owned Enterprises Source: McKinsey

Capital Allocation: Too Scarce in Inland Areas: 

Capital Allocation: Too Scarce in Inland Areas Source: METI

Capital Allocation: Can Heighten Regional Inequalities: 

Capital Allocation: Can Heighten Regional Inequalities Source: METI

3. Money Supply: China’s M2/GDP out of proportion: 

3. Money Supply: China’s M2/GDP out of proportion http://www.allcountries.org/china_statistics/index.html

4. Informal Finance:: 

4. Informal Finance: “ All small business start with loans from family and friends. I’m not aware of any business that was started with bank financing.” - Manager of one of Shanghai’s 10 largest Private Firms (McKinsey)

Slide11: 

Informal Financial Intermediaries Source: McKinsey 28%

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

5. Small Government Bond Market: Makes Central Bank’s Job More Difficult Source: McKinsey

II. Adverse Selection by Credit Rating Error: 

II. Adverse Selection by Credit Rating Error Think of two firms which must go through a long difficult process – just to achieve the same credit rating. But say the 1st firm is a good risk, while the 2nd firm is a poor risk. (So there is Rating Error.) Which firm will be more determined to complete the rating process?

Empirically Based Simulation of Credit Rating Effects:: 

Empirically Based Simulation of Credit Rating Effects: “Modeling the economic value of credit rating systems”, by Jankowitscha, Pichlera, and Schwaigerb Journal of Banking & Finance Volume 31, Issue 1, January 2007, Pages 181-198

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

Adverse Selection: History of 30,000 Austrian Corporate Loans Source: Jankowitsch et. al., Journal of Banking & Finance (2007)

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

Adverse Selection: Basis Point Improvement in Change from Low Credit Rating Accuracy Source: Jankowitsch et. al. (2007)

Adverse Selection: 

Adverse Selection The study finds this improvement in return is mostly due to less adverse selection – not better loan pricing. As a very distinguished banker friend of mine once said: “If you lose the principle, it’s hard to make it up on interest payments.”

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

III. Macro-economic Stability and Loan-Loss-Reserve Regulation “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way, along with his fellows, so that no one can really blame him.” J.M. Keynes (1931)

Macro Stability: Keynes noted the “Paradox of Thrift”: 

Macro Stability: Keynes noted the “Paradox of Thrift” Consumers cut back on their spending and save more during a recession. This only makes the recession worse. Similarly, Loan Loss Reserves (LLR) are often raised in a recession, just when banks can least afford them – often ensuring their collapse and worsening the recession.

Macro Stability: Perverse Loan-Loss Regulation: 

Macro Stability: Perverse Loan-Loss Regulation Laeven, Luc & Majnoni, Giovanni, 2003. "Loan loss provisioning and economic slowdowns: too much, too late?," Journal of Financial Intermediation, Vol. 12(2), April, pages 178-197. 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.: 

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 recessions: 

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

Tentative Conclusions:: 

Tentative Conclusions: China’s Monetary Policy challenge is very difficult, with few policy instruments A good Credit Rating System has great potential for improved financial returns from banking However, poor regulation based on credit rating has the potential to increase macro-economic instability

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