Challenges for Monetary Policy in China:

1
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
2
I. Overheating

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

3
1. Evidence of Overheating Inflation Spike
Source CIA Factbook, and June 2007 Figures
4
Evidence Real Estate Prices
5
Evidence Shanghai Engineers Salaries Higher
than in Thailand, Indonesia, Philippines
Source METI - China and ASEAN4
6
2. Capital Allocation State Banks to
State-Owned Enterprises
Source McKinsey
7
Capital Allocation Too Scarce in Inland Areas
Source METI
8
Capital Allocation Can Heighten Regional
Inequalities
Source METI
9
3. Money Supply Chinas M2/GDP out of proportion
http//www.allcountries.org/china_statistics/index
.html
10
4. Informal Finance

• All small business start with loans from family
  and friends. Im not aware of any business that
  was started with bank financing.
• - Manager of one of Shanghais 10 largest Private
  Firms (McKinsey)

11
Informal Financial Intermediaries
28
Source McKinsey
12
5. Small Government Bond Market Makes
Central Banks Job More Difficult
Source McKinsey
13
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?

14
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
15
Adverse Selection History of 30,000 Austrian
Corporate Loans
Source Jankowitsch et. al., Journal of Banking
Finance (2007)
16
Adverse Selection Basis Point Improvement in
Change from Low Credit Rating Accuracy
Source Jankowitsch et. al. (2007)
17
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, its hard to make it
  up on interest payments.

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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)

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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.

20
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
21
They argue that LLR should be pro-cyclical,
built up in good times, so that it is available
for bad times.
22
Instead, LLR growth counter-cyclicalWeak LLR
in booms spurs inflation, Strong LLR in busts
worsens recessions
23
Tentative Conclusions

• Chinas 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