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