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Financial Reform Policies for Rebalancing Economic Growth

Nicholas Lardy        2013-02-19

 

Rebalancing the sources of growth in China is the top economic issue facing the Chinese leadership. The aftermath of the global financial and economic crisishas underlined the centrality of the economic rebalancing agenda first adopted in 2004.  China faces an extraordinarily weak external environment. Although the recession in the US officially ended in June 2009, the pace of recovery has been quite weak relative to earlier, post-war recessions.  Europe’s recovery has been even weaker and the prospects for returning to the pre-crisis pace of growth quite dim in view of the need for many Eurozone countries to significantly reduce  fiscal deficits in an attempt to bring down the magnitude of their sovereign debt to sustainable levels.  In this global environment the prospect that China’s exports can grow at anything like the pace of the previous decade are quite dim. Given that investment is already far too high as a share of GDP, the only sustainable source of future growth is more rapidly rising private consumption expenditure. Though there are many policy changes that must occur to promote more rapid growth of consumption, the most important reforms must come in the financial sector.

Successful rebalancing of the sources of economic growth, away from investment and exports and toward consumption, would also lead to changes in the structure of production.  Since investment goods, such as machinery and equipment, are produced in the industrial sector, a smaller role for investment in generating economic growth would imply that, over time, the share of GDP originating in the manufacturing sector would be reduced as compared to the “business as usual” investment-driven growth model.  Similarly, since almost all of China’s exports are manufactured goods, less reliance on the expansion of net exports would also imply over time that the share of GDP originating in the manufacturing sector would be reduced as compared to the existing export-driven growth model.[1]  Since services account for about a third of personal consumption outlays, an increasing role for consumption in generating economic growth implies that the share of GDP originating in the services sector would increase over time as compared to an investment- and export-driven growth path.[2]

Finally rebalancing would have important implications for the shares of national income accruing to households, corporations, and the government.  Raising household consumption as a share of GDP depends primarily on increasing the share of national income accruing to households.  Greater provision of social services by the government depends primarily on increasing the share of national income accruing to the government.  Obviously, these changes will require a reduction in the share of national income in the hands of corporations.

 

Financial Reform 

The most important domain to promote economic rebalancing is in the financial system. The key element of financial reform is not the introduction of complex financial instruments but rather eliminating the remaining government controls on interest rates on both deposits and loans.  Throughout the reform period the authorities have controlled interest rates in a manner that has led to a relatively low average real rate of return on household bank savings.[3]  In effect depositors have been taxed so that borrowers, historically mostly state-owned corporates, can have access to cheap credit. 

This implicit tax on depositors appears to have increased significantly around 2004.[4]   The average real return on a one-year deposit for the years 1997 through 2003 was 3.0 percent. Strikingly, the real one-year deposit rate was never in negative territory during this period except during the last two months of 2003.  In contrast, during the years 2004 through 2011 the real one-year deposit rate was in negative territory more than half the time and the average real rate fell to -0.5 percent. Thus the negative returns earned by savers in China today are not explained by the low interest rate policies many central banks around the world adopted in 2009-2010 to promote recovery from the global financial and economic crisis.  Low real deposit rates in China are a phenomena dating back to around 2004.

These low real rates are the direct result of a change in the central bank policy on the adjustment of nominal deposit rates.  From 1997 through 2003 when inflation picked up the central bank raised the one-year nominal deposit rate with a very short time lag.  The inverse was true when the pace of inflation ebbed.  In contrast, beginning in 2004 whenever inflation picked up the central bank raised the nominal one-year deposit rate with a lag and the upward adjustment was substantially less than the increase in inflation.  When inflation ebbed the bank adjusted the nominal deposit rate downward rather quickly. 

The direct result of the way the central bank has set nominal rates since 2003 is that household interest earnings on average have been far less than they would have been in a more liberalized financial environment where market forces play a major role in determining interest rates.   The decline in property income (of which more than four-fifths is interest income) received by households accounted for about one-fifth of the decline in household disposable income as a share of GDP between 1992 and 2008.  This is particularly noteworthy because the stock of household savings relative to GDP grew substantially over these years.  In short, because of negative real interest rates the growth of household income since 2003 has been below the path that would have been attained in a more liberalized (less repressed) financial environment.

The indirect effect of negative real deposit rates in China seems to be that households increased the share of their disposable income that they saved. The response of households generally to a change in interest rates reflects the combination of offsetting substitution and income effects. While there is no theoretical presumption of which effect will dominate, empirically usually the substitution effect is larger.  Thus a reduction in the real interest rate would be expected to lead to a lower household savings rate.  However, if the primary motivation for savings is to achieve a certain target level of financial assets, the income effect would dominate, i.e. as the real return to savings declines, in order to achieve their target level of savings, households would save more (consume less) from their current income. The hypothesis that the primary motivation for Chinese household savings is to achieve a target level of savings makes sense in a society where medical insurance coverage is still limited, hospital access usually depends on paying cash in advance, and  relatively high down payments are required to qualify for a mortgage on a residential property.  There is also empirical support, based on a detailed analysis of Chinese household data, for the hypothesis that a decline in the real interest rate leads to an increase in the household savings rate.[5]

The aggregate data on household savings from the flow of funds show that in 1997-2003, when the real one-year deposit rate was positive, household savings averaged 29 percent of disposable income; in 2004-2009, when the average real rate of return on one-year deposits turned negative, household savings jumped to an average of 38 percentof disposable income.[6]  Thus the aggregate data also support an inverse relationship between the real interest rate and the household savings rate.  The rise in the household savings rate accounted for about one-quarter of the long-term decline in household consumption as a share of GDP.

Market determination of deposit rates would eliminate the element of financial repression that imposes a high implicit tax on Chinese savers. Interest rate liberalization would raise household consumption as a share of GDP through two mechanisms.  First, higher real deposit rates would increase household income and, for any given savings rate, also increase household consumption as a share of GDP. This might be thought of as the direct effect. 

Second, liberalization of deposit rates would also spur household consumption indirectly.  Since household savings is to a substantial extent motivated by precautionary demand, when the government suppresses real interest rates on deposits, households that are seeking to achieve a certain target level of savings will increase their savings rate to make up for the lower real return.  If the government were to liberalize deposit interest rates, the household savings rate would likely decline, i.e. households would choose to spend a higher share of their income.  This might be thought of as the indirect effect of interest rate liberalization. 

Thus the combined direct and indirect effect of liberalizing deposit rates could be to raise the share of private consumption in GDP by as much as 6 percentage points.[7]  That alone would reverse about two-fifths of the long-term decline in the share of household consumption in China’s GDP.

Financial reform should also address other elements, in addition to low deposit interest rates, of China’s financial system that reflect financial repression.  These elements include the very high required reserve ratio and compulsory quotas imposed on banks requiring them to hold both large quantities of government bonds issued by the Ministry of Finance and bills issued by the central bank.The low yields on government bonds and central bank bills and the fact that these financial instruments are held predominantly by banks are two further indicators of financial repression, in addition to the negative real interest rate on household deposits.  In the earliest days of the government bond market in the 1980s continuing into the 1990s individuals were the dominant bond investors and the Ministry of Finance (MOF) and corporate bond issuers (almost all state-owned companies) had to pay market-oriented interest rates to sell the bonds.[8]  But over the past decade MOF increasingly placed government bonds directly with the banks at interest rates dictated by MOF that were designed to lower the ministry’s interest expense.  The funds raised by MOF thus came indirectly from household depositors via the banks, rather than directly from the households.  By 2009 individuals held only 1 percent of all outstanding bonds while banks held over 70 percent of all fixed-income securities, including 50 percent of all Ministry of Finance Bonds and  almost all central bank bills. These low-yielding bonds accounted for an unusually high 20-30 percent of total bank assets.[9]

While substantially increased government social expenditures, increased pension payments, and increased transfer payments to the lowest-income urban and rural residents are potentially contributing to economic rebalancing, the government has discussed but not yet adopted financial and banking reforms that would support the transition to consumption-led growth.  Indeed in two respects financial policy has retrogressed since 2004.  First, a policy of gradual liberalization of interest rates initiated in 1997 was suspended between late 2004 and June 2012 .  Second, as already noted, from the perspective of households the financial system has become more—not less—repressive since around 2003.  Following a brief summary of the history of interest rate liberalization we turn to a more detailed estimate of the implications of financial repression for households.

The People’s Bank of China initiated a program of market-oriented interest rate liberalization in 1997 when, for the first time, it allowed financial institutions the flexibility to set interest rates on loans at a level somewhat higher than the benchmark rates set by the central bank.  For example, the flexibility that commercial banks had in setting lending rates to small enterprises was increased.  Prior to 1998 the margin was limited to 10 percent above the benchmark rates set by the central bank.[10]  In 1998 this margin was increased to 20 percent.  Thus, for example, in the second half of 1998 when the benchmark interest rate on a one-year working capital loan was 6.93 percent, banks were allowed to set rates as high as 8.32 percent.  Subsequently the People’s Bank authorized commercial banks this kind of flexibility to set lending rates for all types of borrowers.   Rural credit cooperatives were given even greater flexibility and were allowed to charge interest rates on loans as much as 50 percent above central bank benchmark rates as early as 1998.  Flexibility for rural credit cooperatives rose to 100 percent starting in September 2002.  The central bank also decontrolled the interest rates for both deposits and loans in foreign banks that were denominated in foreign currency. 

This liberalization of interest rates peaked in 2004 and has only recently resumed.  At the beginning of 2004 the People’s Bank raised the upper limit on the lending rates that could be charged by commercial banks and urban credit cooperatives from 1.3 times the benchmark to a new limit of 1.7 times.  Finally, in late October 2004 the central bank raised the flexibility of lending rates for both urban and rural credit cooperatives to a maximum of 2.3 times the benchmark and completely removed the cap on lending rates charged by commercial banks.  These gradual steps marked an important relaxation of central bank control of interest rates. They were part of the government’s effort to encourage banks to operate on a commercial basis.  A key aspect of this, of course, is the pricing of risk.  Prior to 1997 banks had little incentive to develop risk pricing skills since every loan had to be made at the same benchmark interest rate. 

But in one critical respect these steps fell short of full liberalization. The central bank maintained the cap on deposit rates for all institutions and also mandated that lending rates could not fall below 0.9 times its established benchmark rates.[11] Thus banks, in effect, were guaranteed a minimum interest rate spread. October 2004 marked the beginning of an extended suspension of market-oriented interest rate reform (lixi shichanghua gaige), first announced by the central bank in 1996.

But Premier Zhu used the same “market oriented interest rate reform” phrase in his speech to the National People’s Congress in 2009, putting market-oriented interest rate reform back on the policy agenda. But not until the first part of 2012 did the central bank further widen the bands around the benchmark interest rates and, more importantly, for the first time allowed a modest amount of upward adjustment from the benchmark in deposit rates.

If financial repression has increased since 2003 what are the concrete implications for households?  One way to measure the implicit tax imposed on households by the decline in the real rate of interest that banks pay households on their savings deposits is to ask how much more households would have earned on their savings if the real interest rates prevailing at some point after 2003 had been the same as in 2002.  We measure the decline from 2002 for two reasons.  First, on February 21, 2002 the central bank set the interest rate that banks could pay on demand deposits at 0.72 percent and then left that rate unchanged until November 2008 despite a substantial pick up in price inflation over the period.  Negative real interest rates on deposits are closely related to China’s exchange rate policy and 2002 predates the emergence of an undervalued exchange rate of the renminbi. As previously noted, the real rate of interest on one-year bank deposits was continuously positive until the closing months of 2003.  For example, starting in February 2002 the central bank set the interest rate on one-year deposits at 1.98 percent while the consumer price index declined 0.8 percent that year, making the real rate of interest 2.78 percent.  That is close to the average real interest rate of 3.0 percent on one-year deposits that prevailed in the years from 1997 through 2003. 

By contrast, after 2002 consumer price inflation rose and the central bank adjusted nominal time deposit rates upward by only small amounts and left the nominal interest rate on demand deposits unchanged for more than six years.  In the first half of 2008 consumer price inflation was 7.9 percent, meaning that the real rate of return on demand deposits had fallen to -7.18 percent, a decline of 8.7 percentage points.  The central bank did increase the nominal interest rate that banks could pay on term deposits of various maturities.  For example, the central bank had moved up the rate on one-year deposits by mid-year 2008 to 4.14 percent.  But in real terms the rate was -3.76 percent, a decline of 6.54 percentage points compared with the real return on one-year deposits in 2002.

To measure the implicit tax on household savings in the first half of 2008 start by noting that household bank deposits during that period averaged RMB18,680 billion.[12]  Almost two-fifths of this was in the form of demand deposits and the balance was in term deposits of maturities ranging from as short as 3 months to as long as 5 years.  If these deposits had earned the same real rates as in 2002, household income in the first half of 2008 would have been RMB690 billion greater than it actually was, an amount equal to 5.3 percent of China’s GDP in the first half of the year.  That means that the average negative real deposit rates prevailing after 2003 significantly retarded the growth of household income making the contribution of household consumption to economic growth less than it would have been in a system with market-determined interest rates.

In addition to contributing to economic imbalances by constraining the growth of household income and consumption, the central bank’s low interest rate policy also has contributed to another dimension of economic imbalance, China’s exceptionally high rate of investment since 2003. The simplest explanation is that there was a marked decline in real lending rates after 2003. In 1997-2003 the real rate on a one year loan averaged 6.8 percent.[13]But from the beginning of 2004 through 2011 the real interest rate on a one-year loan averaged only 1.79 percent, encouraging investment in projects that have much lower returns and thus boosting the investment share in GDP.   

The government’s policy of low interest rates on deposits indirectly depresses interest rates on loans.  This occurs largely because of competition among banks.  The low benchmark rate the central bank set on deposits gives commercial banks a very cheap  source of funding.  Bank profitability in recent years has been quite high, even though the banks do not take much advantage of the flexibility they have had since the fall of 2004 to set lending rates at any point above 0.9 times the benchmark rates.[14]  Except for borrowers that are unusually risky, banks are unable to set loan rates much above the benchmark because other banks would undercut their rates. The contribution of competition among banks to low lending rates is reinforced by the large savings-investment imbalance that emerged after 2003, reflected in China’s large current account surplus. With the country awash in liquidity, market forces kept lending rates low.

The influence of low interest rates on investment is particularly noticeable in investment in residential real estate.  The increase in residential real estate investment is responsible for a large share of the increase in the average investment share of GDP after 2003. China’s financial regulators have hadsome success in limiting the buildup of financial leverage that could substantially exacerbate the economic effect of a collapse of property prices.  But the authorities have been much less successful in controlling the macroeconomic risk that GDP growth could decelerate significantly as a result of a marked slowdown in the pace of property investment.  Investment in residential real estate by property development companies averaged only 2.4 percent of GDP in the early years of the housing boom, 1996-1999.[15]  In 2000 through 2003 this rose to an average of 4.1 percent.  Subsequently, as real returns to financial saving fell into negative territory, investment in residential real estate soared, reaching 9.4 percent of GDP in 2011.[16]

This rise in residential real estate investment in China does not appear to be the result of either a rapidly rising rate of home ownership in urban areas or rapidly rising urbanization.[17]  The sharpest rise in home ownership in China occurred in the mid-1990s as a result of a massive, probably historically unprecedented, privatization of the urban housing stock, almost all of which was owned by government agencies and state-owned enterprises.  This housing was sold to the then-current residents, mostly at prices that were heavily discounted relative to replacement cost. In 1998, when this privatization process was near completion, the home ownership rate in urban areas reached 80 percent, up from 9.7 percent in 1983 when economic reform was just getting underway.  Most of this increase must have occurred in 1996-1998 at the height of the privatization process. In subsequent years the homeownership rate rose very gradually, albeit to very high levels—82.1 percent by 2002, 87 percent by 2006, 87.8 percent by 2008, and 89.3 percent by the end of 2010.[18]

Similarly rapid urbanization is not a satisfactory alternative explanation of the long-term rise in the share of GDP allocated to residential real estate investment. In 2000-2003 China’s urban population was rising by about 24 million per year and these new urbanites were being accommodated with residential investment equal to an average of 4.1 percent of GDP and residential housing starts that rose from 240 million square meters per year in 2000 to 440 million square meters in 2003. Since 2003 the urban population increased by an average of only 19 million annually but average residential housing investment of 6.8 percent of GDP was two-thirds larger than in 2000-2003 and annual residential housing starts soared from 490 million square meters in 2004 to 1,290 million square meters in 2010.[19]

Thus the rise in residential real estate investment in China in the previous decade was not the result of a rapidly rising rate of home ownership or an accelerating pace of urbanization.  Rather it was because residential real estate became a preferred asset class, particularly for urban residents.  There were several reasons for this.  First, the real returns to bank deposits declined dramatically and on average for one-year deposits were negative in real termsafter 2003.  In contrast, returns to newly constructed residential property, though varying widely by location, averaged 2.3 percent per annum in real terms in 1998-2003 but rose to 4.6 percent in 2004-2010.[20] In other words the average real return on a one-year bank deposit exceeded the average house price appreciation by 0.7 percent in 1998-2003 but in 2004-2010 the relationship flipped and in real terms the average house price appreciation exceeded the one-year deposit rate by an average of 4.9 percent.

Second, the financial terms for individual mortgages were favorable for two reasons.  First-time property buyers were able to borrow at a discount of 15 or 30 percent to the benchmark lending rate set by the central bank for the tenor of their mortgage. And second by taking out a mortgage a household could reduce their share of the implicit tax levied on household bank deposits.  This was because a household that secured a mortgage to purchase a residential property reduced their net deposits (equal to deposits minus loans) in the banking system for two reasons.  First, some of the funds previously the household had on deposit in the banking system were converted into a down payment.  Second, the household further reduced its net deposits by taking out the individual mortgage loan.

Third, there was no property tax, so the carrying costs of owning an empty flat were modest.[21]

Fourth, because the Chinese currency remained largely inconvertible on capital account most households had no legal opportunity to shift part of their savings into higher-yielding, foreign-currency denominated financial assets. The State Council did approve the introduction of a qualified domestic institutional investor (QDII) program in 2006 that allows households to place renminbi funds with licensed domestic financial institutions that invest the funds on their behalf in foreign-currency denominated financial assets.  But by the end of 2010 the total approved amount of QDII funds was only $68.4 billion, equivalent to only 1.5 percent of the value of household bank deposits.[22]

Fifth, weak governance as well as the high price volatility typical of immature equity markets led to a lack of confidence among many retail investors in the Shanghai Stock Exchange.  As early as 2001 Wu Jinglian, China’s leading academic reform economist, reflecting widespread concerns about front running, insider trading, and other trading abuses, characterized the Shanghai Stock Exchange as a “casino” in which household investors inevitably would lose moneyover the long-run.[23]  After a massive run-up in prices the Shanghai Stock Exchange A-share market index peaked in October 2007 at 6,251.5.  Subsequently, even before the onset of the global financial and economic crisis, the market sold off, with the index falling by more than half by mid-year 2008.  The market then plunged further, with the index hitting a low of about 1,800 at the time of the Lehman collapse in the fall of 2008. Subsequently the market recovered somewhat but by end-June 2012 the A-share market index stood at only about 2,225, less than half its peak level in October 2007.  Most Chinese households, having been burned by the stock market, have limited their equity investments. UBS estimates that equities accounted for only a little more than 10 percent of urban household wealth in 2010 while bank deposits and real estate accounted for 42 percent and 40 percent, respectively. Furthermore, the corporate bond market is tiny and government bonds yields so low that bonds are not an attractive investment for individual investors.  It is therefore not surprising that bonds accounted for only about 1 percent of urban household assets in 2010.[24]

The extent to which real estate has become a preferred asset class in urban China is reflected not only in the run up in investment in residential property as a share of GDP, but also in the surprisingly high share of urban households that own multiple homes.  For example, according to a fourth quarter of 2010 survey of the Chinese central bank, 18.3 percent of all households in Beijing owned two or more properties.[25] Much, if not most, of this property is vacant, in part because the rental yields on property in tier-one cities such as Beijing, Shanghai, and Shenzhen are very low.[26] But ownership of multiple properties is not limited to tier-one cities.  At mid-year 2010 the share of all residential properties purchased in all Chinese cities as an investment hit a peak of over 40 percent and, despite the various measures the government introduced starting in December 2009 to discourage property investors, at mid-year 2011 more than 20 percent of all purchases of residential property still were for investment purposes.[27]

The pervasiveness of property as a desirable investment class has a further important implication for the evolution of the household savings rate.  One motive for household savings is to be able to make the down payment for a mortgage on a residential property. That could support the conjecture that the household saving rate might fall as the share of urban residents who have already purchased a home rises to relatively high levels.  But property ownership among permanent urban residents had already reached very high levels by the early 2000s, but the household savings rate began to rise at that time.  Perhaps this reflects the rise of property as a preferred asset class.  If, after a first-time property purchase, over time a growing share of homeowners desire to own a second property, the household savings rate might even rise as a growing share of households not only was paying down their first mortgage (which counts as savings), but also began to save for down payment on a mortgage to acquire an additional residence.

The main risk that China faces is not that borrowers will default on their mortgages as the result of a correction in property prices, leading to a financial crisis as occurred in several advanced industrial countries during the global financial and economic crisis.  The Chinese bank regulator requires banks to collect substantial down payments as a condition for issuing a residential mortgage, particularly for property investors, and household mortgage debt is a relatively low share of household disposable income.  The risk arises instead because at some point households may no longer perceive housing as a preferred asset class. That would mean a sharp drop in residential investment.  Since residential investment by 2010 accounted for a substantial share of national investment, that drop would lead to a substantial slowdown in economic growth.

As Wang Tao has pointed out, housing could lose its preferred asset class status for a number of reasons: a sharp rise in interest rates;[28][29] the liberalization of portfolio capital outflows for households; improved regulation of the Shanghai Stock Exchange that gives investors’ confidence in equities as a viable long-term investment class; the emergence of another asset class that draws investment away from property; or a price decline that leads to negative real returns on property investment.

We might add to this list more widespread and higher taxation of property that increases the carrying cost of investing in property and the desire on the part of households for greater diversification of their wealth holding.  As already noted, prior to the mid-1990s urban households held little of their wealth in the form of property.  By 1997, after the housing privatization campaign was well underway, property accounted for a fifth of the estimated wealth of urban households. 

But by 2010 the property share of urban household wealth reached two-fifths. Three factors accounted for the doubling in the real estate share of household wealth in a period of just over a decade.  First, as already noted, residential investment as a share of GDP rose ever higher as urban residents moved to ever larger and higher quality residences.  Second, real estate price appreciation on average picked up starting in 2004 while beginning in late 2007 equity prices fell sharply and by mid-2012 had recovered only very partially. Third, a significant share of urban households purchased a second or even third property.  At some point households may decide that they have enough exposure to property as an asset class and thus seek to diversify the composition of their wealth.  When this happens the demand for property could slump, causing prices to fall.

The macro risk of a residential property slump arises not because of high leverage in the property sector, though some property developers could be forced into bankruptcy in a property downturn.[30]  It arises because property investment accounts for a large share of total national investment, residential real estate accounts for more than three-quarters of all property development, and a very large share of economic activity in China is linked to property development, either directly or indirectly. Forty percent of steel output goes directly into real estate and when steel used in appliances, the sales of which are highly correlated with housing development, is added the share rises further.  Taking into account the entire upstream supply chain connected to property, UBS estimates that property accounts for as much as one-quarter of final demand in China.[31] When these connections between property and other sectors are considered, it becomes clear that a property slump immediately would have widespread adverse macroeconomic consequences.

The adverse effect of a significant residential property price correction likely would be long-lived for three reasons.  First, there is a large overhang of vacant residential properties purchased by investors that expect ever rising property prices.  If there was a significant price correction many of these properties would come back onto the market, pushing prices down further and depressing the level of new construction.  Second, since residential property is a large share of urban household wealth, a sharp price correction would reduce household wealth and thus have an additional adverse effect on economic growth through its negative effect on household consumption expenditure. Third, a property slump would have large negative fiscal consequences for local governments.  A sharp drop in new housing starts would cause income from land sales and leasing to plummet, impairing the ability of local governments to provide social services and finance local infrastructure projects, further reducing aggregate demand. Moreover, a sharp decline in revenues from land leasing could impair the ability of local governments to repay the debts of local investment companies.  A significant share of this debt is secured by land or income from land leasing.  This, in turn, could lead to the reemergence of large scale non-performing loans in the banking system

A comparison with the United States may be instructive.  During the 2002-2006 U.S. real estate boom investment in residential real estate averaged 5.5 percent of GDP, up less than a percentage point from the long-run average of 4.7 percent of GDP in 1950-2001.[32] At the peak of the bubble in 2005 about 2 million new housing units were constructed and housing investment accounted for 6 percent of GDP.  The burst of the property bubble led not only to the global financial and economic crisis, but also a long period of subpar growth in the United States.  Even after the US economy began to recover in the second half of 2009 economic growth was subdued, largely because investment in residential real estate  remained depressed.   In the final quarter of 2010 investment in real estate in the United States was just 2.5 percent of GDP. Toward the close of 2012 some analysts argued that the housing market had begun to recover, but the share of investment going to real estate remained at about 2.5 percent, barely more than half the long-term share.  The clear lesson is that the real estate boom was responsible for pushing up US growth in the years 2002 through 2005 and the bursting of the property bubble drove the economy into the deepest recession since the depression.  Most important housing was a drag on US economic growth for more than three years after the general economic recovery began and  it will likely be several additional years until housing is making what might be considered a normal contribution to US economic growth.  

 

Exchange Rate Policy

More flexibility with respect to the exchange rate of the renminbi is a third domain in which government policy could contribute to China’s desired transition to a more consumption-driven growth path.   Starting in 2004 the central bank engaged in systematic, large-scale intervention in the foreign exchange market, selling domestic currency and buying up foreign exchange, thus leading to a vast build-up of foreign exchange reserves.  Through 2010 the annual increase in reserves averaged 10 percent of GDP taking reserves at year-end 2010 to $2.9 trillion.  In the absence of this unprecedentedly large, one-way, and continuous exchange market intervention, the RMB would have appreciated substantially more than the modest cumulative 24 percent real, trade-weighted appreciation that actually occurred in 2004-2010.[33]

Since 2010 the government has significantly reduced official intervention in the foreign exchange market. Compared to an average of $450 billion in 2007-2010, the build-up of foreign exchange reserves fell to under $350 billion in 2011 and the pace of additions dropped dramatically to only $30 billion in the first three quarters of 2012. Moreover in 2012 there was substantial two way movement in the value of the RMB and on some occasions the central bank actually appeared to be intervening in the market by selling foreign exchange to prevent a more sizeable depreciation of the currency. Thus the value of the currency increasingly is determined by supply and demand in the market. 

RMB flexibility contributes to economic rebalancing in two ways. First, by making exports more expensive and imports cheaper, currency appreciation reduces the growth of exports and increases the growth of imports, reducing China’s large global external surplus. China’s current account surplus in the first half of 2012 fell to only 2.1 percent of GDP, down dramatically from the 10.1 percent peak in 2007.  However, as will be discussed below factors in addition to currency appreciation have contributed to this sharp decline.

The second reason that contributes to the desired transition to a more consumption driven growth path is equally important as the first but frequently overlooked—greater exchange rate flexibility is a precondition for allowing market forces to play a greater role in the determination of interest rates.  The reason is that central bank control of interest rates at very low levels appears to be part and parcel of the policy of keeping the RMB undervalued.  This is certainly suggested by the sharp decline in the real returns to savers after 2003, just when China’s current account surplus began expanding sharply, as a result of  the increasing undervaluation of the currency starting a year or two earlier, and central bank intervention in the foreign exchange market increased significantly.

If domestic interest rates were further liberalized, the costs incurred by the central bank to maintain a significantly undervalued exchange rate would increase dramatically.  This is because, for almost a decade, China’s political leadership saddled the People’s Bank with two potentially conflicting objectives—keeping the currency undervalued and maintaining domestic price stability.  By keeping deposit rates low the central bank, in effect, mitigates this conflict.  When the central bank intervenes in the foreign exchange market, buying up foreign exchange with domestic currency, it can directly control the rate of appreciation of the RMB.  But in so doing it increases the domestic money supply.  Given the unprecedented scale of central bank intervention in the foreign exchange market between 2004 and 2011, without offsetting monetary actions by the central bank domestic price inflation would have become a serious problem. Instead average annual consumer price inflation was a modest 3 percent in 2004-2011.[34]

The central bank takes two types of monetary actions, referred to as sterilization, to offset the increase in the domestic money supply associated with the bank’s intervention in the foreign exchange market. First, the central bank issues bills to commercial banks.  This involves a straightforward commercial bank purchase of interest bearing paper issued by the central bank, resulting in a reduction in the domestic money supply.[35]  Second, the central bank raises the required reserve ratio, the share of deposits that banks must place at the central bank.  Raising the required reserve ratio reduces the money supply below the path it would otherwise take because it limits banks’ ability to expand their lending operations.

In a flexible interest rate environment, a central bank’s sterilization costs usually rise along with increases in the magnitude and duration of its intervention in the foreign exchange market.  As the stock of sterilization bonds rises, investors in these bonds, anticipating that the central bank ultimately may be less than fully successful in controlling inflation, typically will demand an increasingly higher interest rate to be willing to hold larger quantities of the central bank’s paper. On the other hand, the interest rate the central bank earns on the foreign-currency denominated financial assets that comprise its official foreign exchange reserves will likely be stable. Eventually, as these opposing trends play out, the central bank likely will begin to lose money on its foreign exchange operations, i.e. the amount it pays in interest to holders of central bank bills may come to exceed the amount of interest the central bank earn on its reserves.

Setting interest rates administratively at very low levels has allowed the People’s Bank of China to minimize or even avoid these potential financial lossesaltogether. At the end of 2010 there was RMB 4 trillion outstanding in central bank bills, almost all of which was held by commercial banks. Average interest rates paid by the central bank in 2010 were 1.692 percent for three-month bills and 2.136 for one-year maturities.[36]  The alternative use of these funds by banks would have been much higher-yielding loans to customers; thus requiring banks to hold central bank bills constitutes an implicit tax.  In 2010 the average interest rate banks earned on their loans was 6.11 percent, more than 4 percentage points higher than what banks earned on central bank bills.[37]  Thus, ignoring the additional risk associated with loans, as opposed to holding presumably risk-free central bank bills, the tax associated with bank holding of central bank bills in 2010 was about RMB170 billion or 0.4 percent of GDP.[38]

Central bank sterilization via hiking the required reserve ratio, the share of their deposits banks must place at the central bank, also constitutes an implicit tax on banks.  By the end of 2010 the PBC had raised this ratio to 18.5 percent, up 12.5 percentage points from the 6 percent required reserve ratio that applied from 2000 through August 2003.  Given that average bank deposits during 2010 were RMB73.3 trillion, the 12 percentage point increase in China’s required reserve ratio meant banks had to place an additional RMB9.2 trillion on deposit with the central bank compared to what would have been required if the required reserve ratio had remained unchanged.  The interest rate the central bank pays on these reserves was 1.89 percent from February 2002 through October 2008 and has been 1.62 percent since then.  On the same methodology used to calculate the implicit tax imposed on banks by requiring them to hold central bank bills, in 2010 the additional implicit tax on banks associated with the increase in the required reserve ratio can be estimated as RMB450 billion, about 1 percent of GDP. 

Thus, whether by requiring banks to hold ever larger amounts of central bank bills or raising the required reserve ratio, ultra-low interest rates has allowed the central bank to sterilize on the cheap.

While the central bank’s intervention in the foreign exchange market and related off-setting sterilization operations impose a substantial implicit tax on banks, the central bank has offset this tax through its control of deposit rates that banks pay to savers.  As already noted, the ceiling that banks are allowed to pay on deposits is quite low, so low that for one-year deposits the average real interest rate during the years 2004 through 2011 was negative.  In short, while it is not described this way by official sources, it appears as if the banks are willing to put massive amounts of funds into low-yielding deposits at the central bank and to hold significant amount of low-yielding central bank paper in part because they have been implicitly compensated in the form of a very low cost of funds on the deposit side of their business. The low ceiling that the central bank sets on deposits, combined with the floor that is set on lending rates, has allowed banks to earn very generous spreads on their deposit taking and lending business.[39] The generous spread more than compensates the banks for the implicit tax imposed on them by the requirement to hold low-yielding central bank bills and to place funds in low-yielding accounts at the central bank.[40]

A closely related reason the central bank has kept interest rates low since 2003 is to minimize the magnitude of so-called hot money inflows from abroad.  Private investors outside of China, observing China’s rapidly growing external surplus beginning in the middle part of the last decade, widely anticipated that the renminbi would appreciate, either through the central bank moving the nominal exchange rate or through the emergence of higher price inflation in China than in the rest of the world.  To capitalize on this anticipated appreciation these investors wanted to be long renminbi-denominated financial assets. They attempted to do this by evading Chinese controls on capital inflows. These foreign investors expected to earn an amount equal to the interest they would earn on renminbi bank deposits plus any appreciation that occurred between the time they got their funds into China and the time they took them out. The central bank tried to mitigate the volume of these capital inflows by keeping domestic interest rates low relative to foreign interest rates in order to reduce the profitability of these speculative transactions.  In 2006 Wu Xiaoling, a vice-governor of the central bank, stated explicitly that the central bank was keeping domestic interest rates low to maintain a negative spread between domestic and international interest rates but that this entailed a  risk since “the low interest rate environment is prone to resulting in asset bubbles, which we are closely watching and are worried about.”[41] More recently Li Daokui, a member of the Monetary Policy Committee of the People’s Bank of China, explicitly reiterated this concern stating “If China’s interest rates are too high . . . hot money will flow in.”[42]

Thus the central bank has had two closely related reasons to keep deposit interest rates low.  First, low rates enabled the central bank to sterilize on the cheap, mitigating the conflict between its two assigned policy goals.  Second, low rates helped hold down speculative capital inflows and thus reduced the magnitude of foreign exchange purchases the bank had to undertake to keep the currency undervalued and thus also reduced the magnitude of sterilization operations required to maintain price stability.

In addition the central government, and particularly the Ministry of Finance, had yet another reason for the central bank to set a ceiling on the interest rates banks paid on deposits and a floor on the rates they could charge on loans.  They wanted to maintain a wide spread in order to assure that the commercial banks would be profitable.  The government in a series of steps starting in the late 1990s undertook a major recapitalization of several of the largest state-owned banks.  By 2005 the total cost of this recapitalization reached an estimated $4 trillion.[43]  The funding arrangements for this multistep recapitalization process were elaborate and far from fully transparent, but it appears that the People’s Bank of China and the Ministry of Finance split some 85 percent of the total cost.  The balance, in effect, was born by strategic foreign institutional investors that took equity stakes in the banks prior to their public listings. Both the Ministry and the central bank wanted to protect their investment by insuring that banks remained profitable. Since Chinese commercial banks have very little fee income, they depend for their earnings very largely on the spread between their deposit and lending rates, i.e. the net interest margin. 

This interest of the Ministry of Finance in ensuring profits in the banking sector only increased in later years when the China Investment Corporation (CIC) gained control from the People’s Bank of China of Central Huijin, a financial institution that owns large stakes in several of China’s largest banks. CIC, which is controlled by the Ministry of Finance, also assumed responsibility for paying the interest on a special RMB1.55 trillion bond that the Ministry of Finance had issued in 2007 to finance a further reorganization of the financial system.  CIC is dependent on dividend payments paid from bank profits in order to service this debt.  Interest rate liberalization would reduce bank profitability and perhaps require the Ministry itself to assume responsibility for the interest payments on its bond issue, which would place an additional claim on fiscal revenues.[44]

Explicit support for the view that further liberalization of the financial system would raise interest rates comes from Xiao Gang, the Chairman of Bank of China, China’s fourth largest commercial bank.  He stated that interest rate liberalization would reduce bank spreads by almost half, implying that deposit rates would rise but that banks would not be able to fully pass on the higher cost of funds to their customers.[45] This, of course, is an explicit admission that the central bank, by setting ceilings on deposit rates but floors on lending rates, has artificially boosted bank profitability. Nonetheless Xiao Gang has been a consistent advocate for liberalization of interest rates, seeing it both as a means of avoiding asset bubbles that accompany negative real deposit rates and a prerequisite for increasing competition in the banking system, deepening China’s capital markets, and improving the monetary policy transmission mechanism.[46]

Market determined interest rates would lead to lending rates that on average are higher in real terms than has been the case in recent years, thus potentially reducing China’s extraordinarily high rate of investment of recent years.  That would contribute to the leadership goal of reducing China’s dependence on investment as a source of economic growth. Greater interest rate flexibility also would allow the central bank to mitigate macroeconomic cycles by raising real lending rates to moderate investment booms, thus reducing the cyclicality of economic growth. At present the authorities still rely in part on direct controls on the quantity of loans that banks can extend, an imperfect instrument that banks and firms seek to evade through a variety of practices.

Given this background on the direct and indirect contributions that greater exchange rate flexibility could make to economic rebalancing, how has China’s exchange rate policy evolved in recent years?

On July 21, 2005 China introduced a new currency regime that ended the policy of a fixed nominal exchange rate of the renminbi vis a vis the dollar,which it had adopted in the mid-1990s.  The new policy had several dimensions.  First, the central bank immediately revalued the official bilateral exchange rate against the US dollar from RMB8.28 to RMB8.11, an appreciation of 2.1 percent.  Second, it stated that the renminbi henceforth would be managed with respect to a basket of currencies, rather than being pegged to the dollar.  Third, and potentially most important, the central bank said that the exchange rate of the renminbi would become “more flexible” with its value based more on “market supply and demand.”

It is important to note that by the time the People’s Bank announced this policy change in mid-2005, the renminbi was already significantly undervalued on a real, trade-weighted basis, perhaps by as much as 20-25 percent.[47]  This assessment is based both on various technical methodologies and on a qualitative analysis of the evidence from the prior decade, when the renminbi was pegged to the dollar.  It is analytically useful to divide this decade into roughly two periods.  From the middle of 1994, when China abandoned its dual exchange rate system in favor of a single, unified exchange rate and began pegging to the dollar, to February 2002 the dollar was appreciating on a real, trade-weighted basis.  Thus the Chinese currency, again on a trade-weighted basis, also was appreciating by an average of about 3.5 percent per annum.[48]  This pace of real appreciation seems to have been roughly equal to the differential growth of productivity in China’s tradable goods sector compared to that of China’s trading partners.       

The real effective exchange rate of the renminbi from the mid-1990s through 2001 should be regarded as an equilibrium exchange rate. Several factors underlie this judgment.  First and perhaps most important, as already noted, China’s average current account position in this period averaged a very modest 2 percent of GDP and showed no secular trend. 

Second, as mentioned above, prior to mid-1994 the Chinese operated a dual exchange rate system in which privileged importers could buy foreign currency at a favorable rate and others purchased foreign exchange in what were referred to as swap centers where exporters were the source of foreign exchange offered for sale.[49]  The large gap at year-end 1993 between the official rate of RMB5.8 to the dollar and the swap market rate of RMB8.7 to the dollar reflected the substantial overvaluation of the currency at the official rate.  But when the People’s Bank of China unified the rates on January 1, 1994 it did so by moving the official rate to the then prevailing swap market rate. At that point the official rate was probably a bit undervalued but this was corrected when the authorities gradually appreciated the rate over the next 18 months to RMB8.3 to the dollar and then by October 1997 to RMB8.28 to the dollar, the point at which it was rigidly pegged until July 2005.[50]

The third reason for regarding the exchange rate prevailing from the mid-1990s through 2001 as an equilibrium exchange rate is that following the unification of the two exchange rates in January 1994 the central bank substantially reduced exchange controls on current account transactions.  This led in late November 1996 to China’s formal acceptance of the obligations of the International Monetary Fund’s Article VIII, meaning that China had achieved convertibility on all current account transactions and that the government would approve all bona fide requests for foreign exchange for current payments and transfers.[51]  Absent current account convertibility the current account balance might be small but this could reflect limited access to foreign exchange by would-be importers, rather than a true equilibrium exchange rate.

After February 2002, however, the U.S. dollar began to depreciate on a sustained basis.  As a result of the peg to the dollar, the renminbi also depreciated and thus diverged systematically from its previous equilibrium rate.  By the middle of 2005, when the People’s Bank of China announced the change in its currency policy, the renminbi had depreciated by 15 percent in real, effective terms according to the index compiled by the Bank for International Settlements.  But compared to the trend line of appreciation over the previous six or seven years, the degree of undervaluation was greater, about 20-25 percent.[52]

The undervaluation of the renminbi was also reflected in the gradual expansion of China’s external surplus after 2002 and an increasingly rapid buildup of foreign exchange reserves.

The Chinese authorities allowed the renminbi to appreciate about 25 percent on a real, trade-weighted basis between June 2005 and the end of 2008.  However, China’s current account surplus continued to expand rapidly, tripling in absolute terms between 2005 and 2008. As a percentage of GDP the current account surplus reached 10.1 percent and 9.1 percent of GDP in 2007 and 2008, respectively, historically unprecedented levels for a large, trading economy.

The reasons why China’s external surplus continued to expand after the currency began to appreciate are very straightforward.  First, currency appreciation will begin to reduce a country’s external surplus below the path that would have occurred in the absence of appreciation.  But this will occur with a lag of several quarters.  Second, as already pointed out, the starting point in July 2005 was not an equilibrium renminbi exchange rate but a currency that was significantly undervalued.  Third, while the currency appreciated about 6 percent in the second half of 2005, subsequently the pace of appreciation was very modest.  The real, trade-weighted value of the renminbi actually depreciated over the course of 2006 and changed little in the first half of 2007.  Not until the closing months of 2007 through the end of 2008 did the People’s Bank allow the currency to appreciate much more rapidly.

During the global financial and economic crisis the government repegged the renminbi to the dollar for about a 15 month period that ended in late June 2010.  Then the People’s Bank of China allowed the currency to appreciate gradually vis a vis the dollar, much as it had between July 2005 and April 2009.  By June 2011 the renminbi had appreciated by about 5 percent vis a vis the dollar in nominal terms.  But on a real, trade-weighted basis the renminbi depreciated between June 2010 and June 2011 and over the two and a half year period ending in June 2011.

While the value of the renminbi depreciated over the two years ending in December 2010, the current account surplus came down by almost half from its peak of 10.1 percent of GDP in 2007 to 5.2 percent of GDP in both 2009 and fell further 4.0 percent and 2.8 percent in 2010 and 2011, respectively. What accounts for this reduction? Is China’s external economicrebalancing well under way? If so will this external rebalancing be sustained?  The official answer advanced by the Chinese government is yes to both these questions.  In the course of China’s annual consultation with the IMF in the spring of 2012 government officials stated that “prevailing foreign exchange market conditions were close to equilibrium” and that “the renminbi was now close to equilibrium or, at most, slightly undervalued.”[53] The IMF’s interlocutors credited ongoing structural reforms, rising wages, and the recent appreciation of the currency as factors underlying the “sharp decline in the current account surplus.”

The staff of the IMF, on the other hand, forecast that the current account surpluses could rise to 4 to 4.5 percent over the medium term. The IMF staff argued that the substantial reduction in the current account was as much due to the global slowdown and a worsening of China’s terms of trade as it was due to the appreciation of the RMB.  When these cyclical factors are reversed China’s external surplus would rise.

Some independent estimates advance views consistent with those of the IMF.  William Cline’s analysis shows that because of the usual two year lag between an exchange rate change and a change in a country’s external balance, a substantial portion of the decline in China’s current account surplus between the peak 10.1 percent of GDP in 2007 and the 4 percent level in 2010 can be explained by the sizeable real appreciation of the renminbi in 2005-2008, most of which occurred in the closing months of 2007 and in 2008.[54]But with the renminbi actually depreciating between the end of 2008 and mid-year 2011he argued that China’s surplus is likely to begin to rise again when economic recovery strengthens in its main export markets—the United States and Europe.

Conclusion

Increased private consumption expenditure is the key to sustaining China’s growth at a reasonably fast pace over the medium term. Given continued weakness in Europe and a modest pace of economic recovery in the United States net exports will be not be able to contribute as significantly to China’s economic growth as was the case in the mid-2000s.  And investment as a share of GDP, particularly residential property investment, must clearly decline to put China on a sustainable growth path.  Continuing to build out the social safety net, in order to reduce the precautionary demand for savings, and reforming the prices of key inputs that have provided a subsidy to the manufacturing sector are both important policies to rebalance the sources of economic growth.  But financial reform is even more important.  Further liberalizing interest rates would reduce the remaining internal imbalances in China’s economy by increasing household income and reducing the household saving rate. Allowing the exchange rate to continue to be largely determined by market forces, as has been the case in the first three quarters of 2012 is another essential policy.

 

 



[1]   Manufactured goods accounted for 95 percent of China’s exports in 2009 (National Bureau of Statistics of China 2010e, 67).

[2] The estimate of the services share in household consumption expenditures is based on urban and rural household surveys conducted annually by the National Bureau of Statistics of China.

[3] Lardy, Nicholas R. 1998. China’s Unfinished Economic Revolution. Washington: Brookings Institution. p.10.

[4]  For an alternative approach see Huang Yiping and Xun Wang. 2010. Financial Repression and Economic Growth in China. Unpublished manuscript (May). Beijing: Beijing University China Center for Economic. They use six variables to construct an index of financial repression and find that from the mid-1950s through 2008 there has been a long-term decline in financial repression.  Their index reaches a low point in 2006 and then rises in the following two years, which they attribute to a response to the global financial crisis.

[5] Chamon, Marcos, and Eswar Prasad. 2008.Why are Savings Rates of Urban Households in China Rising? IMF Working Paper 08/145 (June). Washington: International Monetary Fund. p. 19.Nabar, M. 2011. Targets, Interest Rates, and Household Saving in Urban China. IMF Working Paper 11/223 (September). Washington: International Monetary Fund.

[6]  At the time of this writing the flow of funds data that give household disposable income and savings based on national income data are available only through 2009.  Household savings rates reported in the aggregate flow of funds data are substantially higher than those reported in the household surveys.  For example, in 2004 the household savings rate calculated from household survey data was 24 percent of disposable income while the flow of funds reported that household savings was 32 percent of disposable income. This differential between survey based measures of savings and national income based measures of savings are common and stem largely from low survey response rates from high-income households that have high savings propensities. See Chamon, Marcos, and Eswar Prasad. 2008. Why are Savings Rates of Urban Households in China Rising? IMF Working Paper 08/145 (June). Washington: International Monetary Fund. p. 7.

 

[7]  For the period covered by the flow of funds data, 1992 through 2009, the decline in interest income received by households (the direct effect of declining real deposit rates)was about 2 percentage points of GDP and the increase in the household saving rate (the indirect effect of declining real deposit rates) was about 4 percentage points of GDP.  Note that the rise in the household savings rate as a share of disposable income was much greater than the rise as a share of GDP since household disposable income is much smaller than GDP and over this period fell by 8 percentage points of GDP.

 

[8] Lardy, Nicholas R. 1998. China’s Unfinished Economic Revolution. Washington: Brookings Institution. p.132.

[9]Walter, Carl and Fraser J. T. Howie. 2011. Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise. Singapore: John Wiley and Sons (Asia) Pte. Ltd. p. 103-109. According to Walter and Howie banks only hold these bonds because they are required by the Party to do so.  I believe that banks are willing to hold large amounts of low-yielding government bonds and central bank bills because they are in effect compensated in the form of low-cost deposits from households.  The low cost of deposits is, of course, a direct consequence of the central bank’s control of the structure of interest rates, particularly the ceiling they place on the rates that banks can pay on deposits. See Lardy, Nicholas R., 2008. Financial Repression in China. PolicyBriefs in International Economics 08-8 (September). Washington: Peterson Institute for International Economics.

 

[10]  The central bank sets specific benchmark lending rates for loans of varying tenors and purposes. For ordinary loans the central bank sets rates for tenors of six months or less, six months to a year, one to three years, three to five years, and over five years. There are different rates for individual mortgage loans and in earlier periods for a variety of other special purposes such as technical transformation loans.

 

[11] Details on the program of market-oriented interest rate reform are available in China Banking Society. 1999. Almanac of China’s Finance and Banking 1999. Beijing: China Financial Publishing House. p. 7 and China Banking Society. Almanac of China’s Finance and Banking 2005. Beijing: China Financial Publishing House. p.4-5.

 

[12] This is the average of the end-December 2007 amount of RMB17,575 billion and end-June 2008 amount of RMB19,781 billion.

[13]  The real rate on a one-year loan is calculated as the nominal rate minus the rate of price inflation as measured by the ex-factory price of producer goods.

 

[14] In 2010, for example, about three-quarters of all loans were made at the benchmark rate or within 10 percent of the benchmark. See People’s Bank of China Monetary Analysis Small Group. Report on Implementation of Monetary Policy, Fourth Quarter 2010 (January 30). Available at www.pbc.gov.cn. (accessed on November 2, 2010).

 

[15]  The measure of residential real estate investment used here is completed investment in residential real estate by property development companies. Since about four-fifths of residential housing investment in rural areas is undertaken by farm households, this measure largely excludes residential housing investment in rural areas.  For data for the years 1998 through 2009 see National Bureau of Statistics of China. China Statistical Yearbook 2010. Beijing: China Statistics Press. p.203. The complete time series from 1996 is available from ISI Emerging Markets, CEIC database.

 

[16]  These figures exclude investment in residential property undertaken by rural households.

 

[17]  The focus here is on urban China because housing in rural areas has always been privately owned.  Even during major political campaigns, such as the Great Leap Forward in the late 1950s and the Cultural Revolution in the 1960s, rural housing was not collectivized.  Equally important it remained an inheritable asset. In contrast in the early 1950s most private urban housing was taken over by the state and for several decades thereafter almost all new urban housing investment was undertaken by local governments or state-owned enterprises.

 

[18]  “The burden of high house prices on housing consumption culture and consumption psychology,” December 31, 2009.  Available at www.gygov.gov.cn (accessed April 12, 2011).  “The Home Ownership Rate for Households Living in Urban Areas Is 89.3 percent,” March 9, 2011. Available at www.hzrei.gov.cn (accessed April 12, 2011). “In What Ways Are People’s Living Standards Improving After All?” March 19, 2008.  Available at www.gov.cn (accessed April 12, 2011). “Last year the urban home ownership rate of urban households reached 82.1 percent,” March 27, 2003. Available at www.jiangxi.gov.cn (accessed April 13, 2011). “Real Estate reform is exceeding an important landmark,” March 11, 2011. Available at www.lhfgc.gov.cn (accessed April 13, 2011). These homeownership rates do not include migrant workers employed in cities since they are not classified as urban residents.

 

[19]  The estimate of the average annual increase in the urban population in 2000-03 and 2004-2010 takes into account the results of the 2010 census, released in May 2011.  The census reported an urban population of 665.6 million in 2010, a very sharp increase of 43.7 million above the previously reported 2009 urban population, which the statistical authorities estimated based on an annual sample survey on population changes.  To calculate the average annual increase in the urban population in the two periods I have adjusted the previous estimates of the annual population in 2001-2009 upward by 3 million in 2001, 6 million in 2002, and so forth up to 27 million in 2009.

 

[20]  Real returns were calculated as the 70 city price increase for newly constructed residential property minus the consumer price index, using annual data for the years 1998-2000 and quarterly data for the years 2001-2010.  Data are from ISI Emerging Markets, CEIC data base.

 

[21]  The pilot property tax programs in Shanghai and Chongqing were not introduced until 2011.

 

[22] Lardy, Nicholas R. and Patrick Douglass. 2011. Capital Account Liberalization and the Role of the RMB. Working Paper 11-6 (February). Washington: Peterson Institute for International Economics. p.11.

People’s Bank of China. Data Report on 2010 Financial Statistics (January 11). Available at www.pbc.gov.cn (accessed on January 13. 2011).

 

[23] “Stock Market Causes Heated Debate,” China Daily, March 13, 2001.  Available at http://www.china.org.cn (accessed April 12, 2011).

 

[24] Wang Tao. Bubble or No Bubble? The Great Chinese Property Debate.  UBS Investment Research, China Focus (March 25, 2011). p.12.

 

[25]  People’s Bank of China Business Management Office, “A Summary of a Survey Investigation of the Demand to Purchase Housing by Urban Residents in Beijing Municipality in the Fourth Quarter of 2010,” December 30, 2010.  Available at www.beijing.gov.cn (accessed April 11, 2011).

 

[26] Rental yields (the ratio of annual rental income to the price of a dwelling) in Beijing, Shanghai, and Shenzhen in 2010 ranged from 2.3 percent to 2.9 percent (Wang Tao 2011b, 7).  In a survey of 59 cities around the world only 3 cities in 2008 had rental yields under 3.7 percent.  “Buy-to-let yields” Economist, August 8, 2008.  Available at www.economist.com (accessed April 19, 2011).

 

[27] Jing Ulrich, China’s Balanced Growth Strategy, J.P. Morgan’s Hands-On China Series, June 13, 2011.

 

[28] Wang Tao. Measuring the Property Bubble in China.  UBS Investment Research, Macro Keys (March 22, 2011). p.4.

 

[29]  Mortgage interest rates are reset annually on the basis of any change in the benchmark lending rates set by the People’s Bank of China.

 

[30]  Property developers at the end of 2010 had RMB832.6 billion outstanding in bank loans for the purchase and leasing of land and RMB2.3 trillion in bank loans outstanding for property development.  Individual mortgage loans outstanding were RMB6.2 trillion. See People’s Bank of China Monetary Analysis Small Group. Report on Implementation of Monetary Policy, Fourth Quarter 2010 (January 30). Available at www.pbc.gov.cn. (accessed on November 2, 2010). However, these numbers understate the debt of property developers.  As property lending by banks tightened up in 2010-2011 developers sought other sources of finance, notably trust products and off-shore bond issuance.  In 2010 the total issuance of property-related trust products was RMB286billion.  Stephen Green, China--Our big real- estate survey, Part 3, Standard Chartered Global Research Special Report, July 4, 2011,  p. 13.  And in the first half of 2011 Chinese companies raised $21.5 billion in international bond markets.  Most of these companies are from the property sector. Robert Cookson, “Fears rise of defaults by Chinese companies,” Financial Times, June 30, 2011, p. 26.

 

[31] Wang Tao. Bubble or No Bubble? The Great Chinese Property Debate.  UBS Investment Research, China Focus (March 25, 2011). p.2.

 

[32]Council of Economic Advisers. 2010. Economic Report of the President. Washington: Government Printing Office. p.121.

[33]Bank of International Settlements, BIS effective exchange rate indices, updated 15 April 2011. Available at http://www.bis.org/statistics/eer/index.htm (accessed April 18, 2011).

 

[34]National Bureau of Statistics of China. China Statistical Abstract 2010. Beijing: China Statistics Press. p. 89.

 

[35]  Large-scale issuance of bills by the central bank began in late 2003 because by that time the central bank had sold its entire holdings of Ministry of Finance bonds.

 

[36] People’s Bank of China Monetary Analysis Small Group. Report on Implementation of Monetary Policy, Fourth Quarter 2010 (January 30). Available at www.pbc.gov.cn. (accessed on November 2, 2010). p.8.

 

[37]People’s Bank of China Monetary Analysis Small Group. Report on Implementation of Monetary Policy, Fourth Quarter 2010 (January 30). Available at www.pbc.gov.cn. (accessed on November 2, 2010). p.4. This was the average weighted interest rate banks received on loans of all maturities, excluding short-term discounted bill lending.

[38]  Calculated on the assumption that bank earnings on central bank bills was an average of the yield on three-month and one-year maturities.

 

[39] Lardy, Nicholas R. and Patrick Douglass. 2011. Capital Account Liberalization and the Role of the RMB. Working Paper 11-6 (February). Washington: Peterson Institute for International Economics.

 

[40] Lardy, Nicholas R., 2008. Financial Repression in China. Policy Briefs in International Economics 08-8 (September). Washington: Peterson Institute for International Economics.

[41]  “China PBOC Concerned About Possible Asset Bubbles,” Dow Jones Newswires, November 26, 2006. Available at http://online.wsj.com (accessed November 27, 2006).

 

[42]  “China Central Bank Adviser Backs Interest-Rate Rises,” Dow Jones Newswire, May 16, 2011. Available at www.wsj.com (accessed May 16, 2011).

 

[43] Ma, Guonan. Who Pays China’s Bank Restructuring Bill? CEPII Working Paper no. 2006-4. Paris: Centre D’estudes Prospective et D’Informations Internationales.

[44] Walter, Carl and Fraser J. T. Howie. 2011. Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise. Singapore: John Wiley and Sons (Asia) Pte. Ltd.

 

[45]  The alternative that would also reduce bank spreads would be a fall in deposit rates but a larger fall in lending rates, which is most implausible in the current environment.  Xiao Gang, “Don’t blame it on the government,” August 6, 2010. Available at http://www.boc.cn (accessed August 27, 2010).

 

[46]  Xiao Gang, “Liberalize interest rates further,” China Daily, January 7-9, 2011, p. 12.

 

[47] Cline,William R., and John Williamson. 2008. Estimates of the Equilibrium Exchange Rate of the RMB: Is There a Consensus and If Not, Why Not? In Debating China’s Exchange Rate Policy, ed. Morris Goldstein and Nicholas R. Lardy. Washington: Peterson Institute for International Economics. Goldstein, Morris, and Nicholas R. Lardy. 2009. The Future of China’s Exchange Rate Policy. Washington: Peterson Institute for International Economics. p.25.

 

[48]  The pace of appreciation of the dollar and the renminbi on a trade-weighted basis, of course, were not exactly the same because the relative importance of various countries as trading partners of the United States and China is not the same.  Appreciation of the US dollar vis a vis the Canadian dollar and the Mexican Peso, for example, would be far more important in determining the trade-weighted value of the U.S. dollar since Canada and Mexico are the largest trading partners of the United States but considerably less important trading partners of China. 

[49]  Starting in 1979 the central government gave up its monopoly on foreign exchange and allowed exporting firms to retain a part of their earnings from exports rather than surrendering them entirely to the government.  The amounts of foreign exchange so retained grew rapidly over time (Lardy 1992, 52-57).

 

[50]  The move from RMB8.7 to RMB8.28 represented a cumulative nominal appreciation of 5 percent.

 

[51] International Monetary Fund. 1997. People’s Republic of China—Selected Issues. IMF Staff Country Report 97/72 (September). Washington. p.132.

[52] Goldstein, Morris, and Nicholas R. Lardy. 2009. The Future of China’s Exchange Rate Policy. Washington: Peterson Institute for International Economics. p.10-26.

[53] International Monetary Fund. People’s Republic of China:2011 Article IV Consultation—Staff Report (July). Washington. Available at www.imf.org (accessed on October 26, 2012). p.20.

[54] Cline, William R. 2010. Decomposing the Reduction in China’s Current Account Surplus from 2007 to 2009-2010. Unpublished manuscript (April). Peterson Institute for International Economics, Washington.

 
 
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