China is moving towards full monetary independence

The world’s second-largest economy is moving towards monetary independence and thereby disrupting the current international monetary system, writes Russell Napier, an asset allocation consultant to financial institutions, for the Financial Times.

China must not only stimulate its economy, but also reduce its debts through inflation. The country has one of the highest ratios of total debt, excluding that of financial institutions, to GDP of major economies at 311 percent. While the debt burden of most countries is shrinking relative to their gross domestic product thanks to high nominal GDP growth and the falling price of debt securities, China continues to report a rise in debt to GDP.

In December 2007, on the eve of the global financial crisis, China’s total non-financial debt stood at 142 percent of GDP. The exchange rate targeting regime, limiting money growth relative to total debt growth, pushed China to ever higher debt-to-GDP levels that eventually brought it to the brink of debt deflation. The time has come for the Chinese authorities to use monetary leverage to generate higher nominal GDP growth. This means allowing the exchange rate to adjust to the level of broad money growth needed to reduce China’s debt burden. The current international monetary system will collapse when China achieves this complete monetary independence.

President Xi Jinping’s recent comments that the People’s Bank of China (PBoC) should launch a bond-buying program to create more domestic liquidity may be the first sign that exchange rate targeting is moving down the policy agenda. The PBoC’s actions to accelerate the growth rate of broad money and generate higher nominal GDP growth are not compatible with a stable exchange rate, especially in an era when trade and capital flows are being shifted away from China as part of “friendshoring” (the deployment of supply chains in friendly countries – translation note) of the United States. It is time for China to implement a different and fully autonomous monetary policy.

Since 1994, China has intervened to prevent the yuan from appreciating, especially against the US dollar. This approach to monetary policy was adopted by most of Asia in 1998. This intervention financed the purchase of government securities of developed countries, primarily the United States, by creating bank reserves in local currency. These purchases, regardless of price, effectively decoupled the risk-free interest rate from the nominal growth rate in the developed world.

The global monetary system created a persistent and artificially wide gap between nominal growth rates and the discount rate, thus inflating asset prices and facilitating the increase in indebtedness. Savers in the developed world were partially freed from funding their own governments and instead turned to private sector funding, which boosted asset prices. The valuation of US stocks, as measured by the Shiller price-to-earnings ratio (averaged over the business cycle – trans.), entered a higher plateau under this monetary system, and private and public sector indebtedness rose to new highs against GDP.

The excess domestic liquidity created by the PBoC’s currency intervention was channeled by China’s state-owned banking system to finance investment and greater production at the expense of consumption. This state capitalism reduced the role that excess liquidity played in raising domestic prices and making China less competitive globally. Thus, China’s external surplus lasted much longer than it would have in a market system. Central bankers from developed world banks adjusted their own monetary policies to fit into global inflationary dynamics increasingly driven by China. The Chinese Communist Party has created a fulcrum, and inflation-targeting central bankers have created “long enough leverage” through interest rate policy and expanding their own balance sheets to “lift the world.”

While the yuan’s decline, in response to much higher growth in the currency’s supply, threatens to export deflation, the rest of the world is highly unlikely to allow China to take an even larger share of world trade. The most likely response is to impose tariffs and draw a clearer line between China’s allies and those gravitating elsewhere. Losing access to Chinese manufacturing capacity brings with it higher global inflation.

Governments in developed countries are now engaged in greater interventionism to ensure that the gross imbalances of the old monetary system (mainly excessive levels of debt) are overcome with minimal socio-political upheaval. Such interventionism takes us back to the system known as financial repression that reduced excessive levels of debt after World War II. This new global monetary system brings radical challenges for investors that they will not be able to navigate without a deep understanding of financial history, Napier concludes.