This morning we got yet another disappointing number for the Chinese economy as the Purchasing Manager Index (PMI) dropped to 47.7 – the lowest level in 11 month. I have little doubt that the continued contraction in the Chinese manufacturing sector is due to the People’s Bank of China’s continued tightening of monetary conditions.
Most economists agree that the slowdown in the Chinese economy is having negative ramifications for the rest of the world, but for most economist the contraction in the Chinese economy is seen as affecting the rest of world through a keynesian export channel. I, however, believe that it is much more useful to understand China’s impact on the rest of the world through the perspective of monetary analysis. In this post I will try to explain what we could call the Sino-monetary transmission mechanism.
China is a global monetary superpower
David Beckworth has argued (see for example here) that the Federal Reserve is a monetary superpower as “it manages the world’s main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy gets exported to much of the emerging world. “
I believe that the People’s Bank of China to a large extent has the same role – maybe even a bigger role for some Emerging Markets particularly in Asia and among commodity exporters. Hence, the PBoC can under certain circumstances “dictate” monetary policy in other countries – if these countries decide to import monetary conditions from China.
Overall I see three channels through which PBoC influence monetary conditions in the rest of the world:
1) The export channel: For many countries in the world China is now the biggest or second biggest export market. So a monetary induced slowdown in the Chinese economy will have significant impact on many countries’ export performance. This is the channel most keynesian trained economists focus on.
2) Commodity price channel: As China is a major commodity consumer Chinese monetary policy has a direct impact on the demand for and the price of commodities. So tighter Chinese monetary policy is causing global commodity prices to drop. This obviously is having a direct impact on commodity exporters. See for example my discussion of Chinese monetary policy and the Brazilian economy here.
3) The financial flow channel: China has the largest currency reserves in the world . This means that China obviously is extremely important for demand for global financial assets. A contraction in Chinese monetary policy will reduce Chinese FX reserve accumulation and as a result impact demand for for example Emerging Markets bonds and equities.
For the keynesian-trained economist the story would end here. However, we cannot properly understand the impact of Chinese monetary policy on the rest of the world if we do not understand the importance of “local” monetary policy. Hence, in my view other countries of the world can decide to import monetary tightening from China, but they can certainly also decide not to import is monetary tightening. The PBoC might be a monetary superpower, but only because other central banks of the world allow it to be.
Pegged exchange rates, fear-of-floating and inflation targeting give PBoC its superpowers
I believe it is crucial to look at the currency impact of Chinese monetary tightening and how central banks around the world react to this to understand the global transmission of Chinese monetary policy.
Take the example of Malaysia. China is Malaysia’s second biggest export market. Hence, if PBoC tightens monetary policy it will likely hit Malaysian exports to China. Furthermore, tighter monetary policy in China would likely also put downward on global rubber and natural gas prices. Malaysia of course is a large exporter of both of these commodities. It is therefore natural to expect that Chinese monetary tightening will lead to depreciation pressures on the Malaysian ringgit.
Officially the ringgit is a freely floating currency. However, in reality the Malaysian central bank – like most central banks in Asia – suffers from a fear-of-floating and would clearly intervene directly or indirectly in the currency markets if the move in the ringgit became “excessive”. The financial markets obviously know this so even if the Malaysian central bank did not directly intervene in the FX market the currency moves would tend to be smaller than had the Malaysian central bank had a credible hands-off approach to the currency.
The result of this fear-of-floating is that when the currency tends to weaken the Malaysian central bank will step in directly or indirectly and signal a more hawkish stance on monetary policy. This obviously means that the central bank in this way decides to import Chinese monetary tightening. In this regard it is import to realize that the central bank can do this without really realizing it as the fear-of-floating is priced-in by the markets.
Hence, a fear-of-floating automatically will automatically lead central banks to import monetary tightening (or easing) from the monetary superpower – for example the PBoC. This of course is a “mild” case of “monetary import” compared to a fixed exchange rate regime. Under a fixed exchange rate regime there will of course be “full” import of the monetary policy and no monetary policy independence. In that sense Danish or Lithuanian monetary policy is fully determined by the ECB as the krone and the litas are pegged to the euro.
In regard to fixed exchange rate regimes and PBoC the case of Hong Kong is very interesting. The HK dollar is of course pegged to the US dollar and we would therefore normally say that the Federal Reserve determines monetary conditions in Hong Kong. However, that is not whole story. Imagine that the Federal Reserve don’t do anything (to the extent that is possible), but the PBoC tighens monetary conditions. As Hong Kong increasingly has become an integrated part of the Chinese economy a monetary tightening in China will hit Hong Kong exports and financial flows hard. That will put pressure the Hong Kong dollar and as the HK dollar is pegged to the US dollar the HK Monetary Authority will have to tighten monetary policy to maintain the peg. In fact his happens automatically as a consequence of Hong Kong’s currency board regime. So in that sense Chinese monetary policy also has a direct impact on Hong Kong monetary conditions.
Finally even a central bank that has an inflation inflation and allow the currency to float freely could to some extent import Chinese monetary policy. The case of Brazil is a good example of this. As I have argued earlier Chinese monetary tighening has put pressure on the Brazilian real though lower Brazilian exports to China and lower commodity prices. This has pushed up consumer prices in Brazil as import prices have spiked. This was the main “excuse” when the Brazilian central bank recently hiked interest rates. Hence, Brazil’s inflation targeting regime has caused the central bank to import monetary tightening from China, while monetary easing probably is warranted. This is primarly a result of a focus on consumer price inflation rather than on other measures of inflation such as the GDP deflator, which are much less sensitive to import price inflation.
The Kryptonite to take away PBoC’s superpowers
My discussion above illustrates that China can act as a monetary superpower and determine monetary conditions in the rest of the world, but also that this is only because central banks in the rest of world – particularly in Asia – allow this to happen. Malaysia or Hong Kong do not have to import Chinese monetary conditions. Hence, the central bank can choose to offset any shock from Chinese monetary policy. This is basically a variation of the Sumner Critique. The central bank of Malaysia obviously is in full control of nominal GDP/aggregate demand in Malaysia. If the monetary contraction in China leads to a weakening of the ringgit monetary conditions in Malaysia will only tighten if the central bank of Malaysia tries to to fight it by tightening monetary conditions.
Here the case of the Reserve Bank of Australia is telling. RBA operates a floating exchange rates regime and has a flexible inflation target. Under “normal” circumstances the aussie dollar will move more or less in sync with global commodity prices reflecting Australia is a major commodity exporter. In that sense the RBA is showing no real signs of suffering from a fear-of-floating. Furhtermore, As the graph below shows recently the aussie dollar has been allowed to weaken somewhat more than the drop in commodity prices (the CRB index) would normally have been dictating. However, during the recent Chinese monetary policy shock the aussie dollar has been allowed to significantly more than what the CRB index would have dictated. That indicates an “automatic” monetary easing in Australia in response to the Chinese shock. This in my view is very good example of a market-based monetary policy.
If the central bank defines the nominal target clearly and allows the currency to float completely freely then that could works “krytonite” against the PBoC’s monetary superpowers. This is basically what is happening in the case of Australia.
As the market realizes that the RBA will move to ease monetary policy in response to a “China shock” the dollar the market will so to speak “pre-empt” the expected monetary easing by weakening the aussie dollar.
Related posts:
Angola should adopt an ‘Export-Price-Norm’ to escape the ‘China shock’
The PBoC’s monetary supremacy over Brazil (but don’t blame the Chinese)
The antics of FX intervention – the case of Turkey
Should PBoC be blamed for the collapse in gold prices?
Malaysia should peg the renggit to the price of rubber and natural gas
Benjamin Cole
/ July 25, 2013Good blogging.
James in London
/ July 25, 2013But what is the trend rate of growth Chinese NGDP and where are they in relation to it?
Lars Christensen
/ July 25, 2013James, I really think that is exactly the issue.
The PBoC clearly seems to think that RGDP trend growth is much lower than earlier and as a result they want to reduce the trend path for money supply growth to curb medium-term inflation risk. That can be a very tricky operation to pull off as we saw a month ago.
Tom
/ July 25, 2013Some smart points. The idea that a central bank “obviously is in full control of nominal GDP/aggregate demand”, though, is crrrrazy. Obviously.
Unless you’re saying the central bank could start spending directly in the real economy, which I don’t think many central banks could or would do, by law or strong tradition.
Lars Christensen
/ July 25, 2013Tom,
Thanks for your comments.
Let me ask you – do you think that a central bank can create hyperinflation by printing money? Then you will have to think that inflation under the control of the central bank and if so you will have to acknowledge that the central bank can determine the level of nominal GDP as nominal GDP is exactly real GDP plus the price level/inflation. It is very simple – the central bank can alway and everywhere fully control nominal GDP – not real GDP, nominal GDP.
Iván Morales
/ July 25, 2013How does this monetary transmission channel work in the case of a country that doesn’t have it’s own currency, e.g. El Salvador, which uses U.S. dollars as it’s currency, and also depends to great extent on exports to the U.S.
Can we directly assume a a perfect import of monetary policy? or are there other factors at work?
I’m trying to write a paper on the subject, but haven’t found literature about monetary policy pass-through in those cases.
Thanks for the very interesting post!
Tom
/ July 25, 2013Hi Lars. No I don’t agree at all. That makes no sense. To create hyperinflation the central bank must print money and the government must spend it, and as inflation develops, the central bank and government must cooperate to continuously print and spend bigger amounts. In every system I know it’s the government that controls the spending. In such a situation, where the central bank is presumably buying debt directly from the government, inflation still can’t happen unless the government spends that newly created money that it receives in return for issuing debt. Otherwise the money just piles up in the government’s current account. Spending is what matters to nominal GDP, not money printing in and of itself. Likewise, hyperinflation stops when the government stops rapidly increasing spending.
It’s natural for people to think of the combination of rapidly accelerating money printing and rapidly accelerating public spending as simply out-of-control money printing. But central banks aren’t to blame in such situations. They have lost their independence and are merely fulfilling the orders of government. It’s the government’s insistence on continually increasing spending as inflation accelerates, and the government’s ability to convince or force the central bank to go along, that causes hyperinflation. This typically happens when governments are unable to raise revenues any other way, and are reluctant to give up spending power in real terms.
In a more normal situation, the central bank creates or “prints” money by buying debt indirectly from the government, which fundamentally isn’t very different from direct monetary financing. But what’s crucial still is how much the government spends. If the money printing coincides with increased deficit spending, that will increase nominal GDP and cause inflation. If the money printing via central bank purchases of sovereign bonds merely substitutes for issuance of sovereign bonds to natural buyers, and deficit spending does not increase, there is no boost to spending or to nominal GDP, except perhaps on private spending through convoluted processes such as perhaps encouraging bank lending, but that’s hard to predict or measure. In the current situation in the US, where QE has been conducted simultaneously with fiscal consolidation, the effect in my opinion is to suppress nominal GDP, not boost it, as the fiscal drag overwhelms the indirect effects of QE on private spending. That said we did see a substantial drop in the personal savings rate and you could argue that was “thanks” to QE.
jeff
/ July 29, 2013Fascinating perspective re: Tom’s comment re nominal GDP targeting and money printing in the wake of fiscal consolidation.
Money velocity via government spending could certainly be the mechanism causing higher prices (the symptom). Staggering amounts of political third rail unfunded liabilities are coming due now and for the foreseeable future. While hyperinflation could be a ways off, the snow ball effect of meeting these liabilities in tomorrows (slowly?) depreciating dollars may be a true “sight” to behold.
Tom
/ July 30, 2013I think I’ve been misunderstood. My point is that governments, not central banks, cause hyperinflation. Central banks have limited power to cause inflation, which is dependent on others’ desire to spend. A central bank that prints money while neither the private nor public sector are much interested in increasing spending will not create inflation. We can test this proposition by comparing the current pace of money printing (not small) with current trends in spending (overall only a bit up), and current rate of inflation (small).
My point is not to suggest that hyperinflation is caused by governments that can’t control their spending. Theoretically it could happen, and maybe even will in Argentina soon. But every hyperinflation episode I know of resulted from a collapse of revenues combined with an attempt by the government to maintain real spending levels through rapidly increasing nominal spending levels. Nothing about the current situation in the U.S. suggests a trend towards hyperinflation.