Note of July 17, 2011: some errors in the graphs are corrected, and the most up-to-date data are added.


Will China's Economy Slow Down?


Chih Kwan Chen

June 30, 2011

1. Introduction

“Globalization" means that all the major economies on he globe are tightly connected. There is no such thing as one economy flourishes whereas others stagnate or decline as so called “decoupling theorists" try to fantasize. The basic structure of the global economy is the division into two distinctive groups. On one side is The United States of America that supplies almost all of the global trade deficit, and on the other side is the group of trade surplus countries, all riding on American trade deficit to thrive. As America runs trade deficit, U. S. dollars flow into the hands of foreign exporters, and then into the hands of foreign governments and large foreign financial entities. Those dollars eventually must be brought back to American money market to be lent out since Dollar is not legal tenders in foreign lands. As the money market is flooded by the returning dollars generated from the runaway American trade deficit, speculators are able to borrow from the pool, increase their leverage and create enormous bubbles of every variety. Thus U. S. economy booms on surface.

The above discussed basic structure of the globalization process can be viewed from a different angle. The trade-deficit generated dollars that crowd into the U. S. money market looking for borrowers are the dollars derived from the pockets of U. S. consumers. If those trade-deficit generated dollars are not returned to U. S. consumers, their buying power of foreign made goods will diminish in time, U. S. trade deficit will winding down, the prosperity of foreign trade surplus countries will sink accordingly and the whole globalization process will collapse. Thus various ingenuous ways are designed to recycle back those dollars into the pockets of U. S. consumers.

During the first phase of the runaway trade deficit of Reagan era, Wall Street speculators borrowed from the pool of those returning trade-deficit-generated dollars and financed the junk bonds issued in conjunction with corporate raiding and leveraged buyout activities. Through this mechanism corporate raiders, stock owners of those targeted companies, and to a lesser extent ordinary stock holders leaped huge capital gains. Thus those trade-deficit-generated dollars were recycled, or trickled down to U. S. consumers. During the second phase of runaway trade deficit of Clinton era, Wall Street speculators borrowed the trade-deficit-generated dollars and financed IPO of emerging tech companies, and thus created the now infamous DOT-COM bubble. The bubble again lifted the whole stock market and money trickled back to the general public eventually. Wall Street speculators found that stock market was not large enough to accommodate the need of recycling enormous amount of dollars generated by the third phase of runaway trade deficit under the watch of Bush Administration and the long-reining Fed Chairman Alan Greenspan. Their focus naturally turned to the largest lending market, the mortgage market. Down payments for prime mortgages were steadily lowered from 20% down to 10% down, and to 5% down to lure more and more mortgage borrowing and home buying. Eventually the down payments were lowered to zero, riding on the fashion of so called “sub-prime mortgages". The spread of sub-prime mortgages allowed “have-nots" to own dream homes, but inflated the housing price bubble further. The middle-class home owners then took advantage of the housing price bubble to undertake aggressive refinancing to convert the sky-rocketing home equities into spendable cash. By this innovative design Wall Street speculators were able to recycle huge amounts of trade-deficit-generated dollars back to U. S. consumers whereas reaping huge profits for themselves serving as the middlemen.

Every bubble requires ever increasing influx of money to sustain. If the rate of increase of the inflow of money slows down, the bubbles burst inevitably. This observation applies well to three larger and larger economic bubbles since the onset of the globalization process as discussed in the previous paragraph. Since those bubbles of the globalization era are the result of runaway U. S. trade deficits, the bubbles burst when the growth rate of the trade deficit slackens. The reason of the slackening growth rate of the trade deficit is the drop of the value of U. S. Dollar versus the currencies of its major trading partners with huge trade surpluses. Up to year 2000 it was Japan that had largest trade surplus with the U. S.. Both the first bubble of Reagan era and the second bubble of Clinton era met their demise when U. S. Dollar fell vs. Japanese Yen and U. S. trade deficit waned subsequently. Since year 2000, China has overtaken Japan as the major trade surplus country vs. the U. S.. The third bubble of Bush era burst as U. S. Congress pressured China to let Yuan appreciate in order to curb U. S. trade deficit with China. During the crash U. S. trade deficit in general shrank and so was the trade deficit with China. As discussed in article 10 The Federal Reserve always takes back the control of the money market from trade deficit after a recession, and this time is no exception. However, the basic structure of the globalization scheme anchored on the trade imbalance persists. In this age of quantitative easing by The Federal Reserve, the connection between the U. S. economy and China becomes stronger than ever, though in a rather strange way as will be discussed in this article.

In the next section China's economy is analyzed from the angle of monetary statistics. In Section 3 the odd phenomena revealed in the analysis is further analyzed to reveal the true cause of China's dynamic growth. The last section is reserved for looking into the future based on the discoveries in Section 2 and Section 3.

2. M2 and Total Assets of People's Bank of China

The monetary statistics released by People's Bank of China tells us a lot about the working of China's economy. To start the analysis from the monetary side, we will study M2 money supply first.

In the first graph at the right, monthly value of M2 money supply, published by People's Bank of China, is plotted as the brown curve in conventional logarithmic scale. M2 money supply is the count of total amount of money deposited in the banking system. Since the role of banks is to lend out the deposits to businesses, larger M2 money supply implies more potential for increased lending and stronger business activities. However, this statement is true only in normal times. The correlation between M2 money supply and the actual strength of the economic activity breaks down from time to time. To illustrate such a divergence quarterly values of Nominal GDP, as published by The National Bureau of Statistics of China, is plotted as purple horizontal bars in the same logarithmic scale as the brown M2 money supply curve. “Nominal" means not adjusted for inflation. Since M2 money supply is not adjusted for inflation, we must compare Nominal GDP with the money supply. The flattening of the purple Nominal GDP curve around the early part of 2009 is due to the global crash, but the brown M2 money supply curve rather jumped up sharply during that period. The reason of this clear divergence is as follows: As the crash came, people were scared so they refrained from spending and deposited more money into banks. Thus the sudden surge of M2 money supply. On the other hand banks were frightened by the crash, too and refrained from lending to businesses. This means the slower business activity and the flattening of the purple Nominal GDP curve. After the crash both M2 money supply and Nominal GDP have resumed same pace of growth as before the crash. In a logarithmic graph, if a portion of data moves along a straight line, it means that the data is growing with a constant rate. The parallel slopes of the brown and the purple curves, excluding the period of crash, imply that M2 money supply and Nominal GDP are indeed growing at the same rate, displaying the usefulness of M2 money supply to predict the growth of Nominal GDP at normal times.

The next question we need to ask is what is causing M2 money supply and Nominal GDP to grow at normal times. For that purpose we need to look at the total assets of China's central bank, People's Bank of China. In a fiat monetary system, a central bank creates money without any backing of gold or silver. However, the central bank does not give away the created money free. It usually gives the money to the government or to the associated commercial banks and financial institutions in exchange for equally valued government issued debt obligations. It also gives created money to various parties in exchange for their foreign currency holding in the process of currency market intervention. Thus the central bank accumulates assets. By looking at the total assets of People's Bank of China, we can see how much money, that is, Yuan have been created by the central bank. The money created by the central bank then flows through the society and stimulates the economy. In general if the velocity of the money flowing through the society becomes higher, so is the economic activity even if the total amount of money created remain constant. That is the reason why the analysis of the total amount of assets of a central bank becomes an important tool to study the economic conditions of a society. In the first graph at right monthly values of total assets of People's Bank of China is plotted as the green curve, again in the same conventional logarithmic scale as other curves.

The green total asset curve grew faster than both M2 Money Supply and Nominal GDP curves before the crash, but the growth rate of the green total asset curve has distinctively slowed down after the crash. Even as the growth rate of M2 Money Supply and Nominal GDP has approaching the normal growth rate before the crash, the growth rate of total asset curve is not catching up. In order to explain this seeming contradiction, we need to look into the components of total assets of People's Bank of China in details.

Among the sub components of the total assets of People's Bank of China one component especially catches the eyes. It is listed as “foreign currency". That item is, of course, the foreign currency in the hands of the central bank of China, so it is nothing but the foreign currency reserve of China. The bank acquired those foreign currencies through its intervention in the currency market to prevent the unwanted appreciation of Yuan against U. S. Dollar. The “foreign currency" item listed under the total assets is expressed in unit of Yuan. On the other hand the regularly announced China's foreign currency reserve is expressed in terms of Dollar. If we translate the Yuan denominated “foreign currency" into Dollar terms using the market exchange rate, the result diverges from the officially announced foreign currency reserve. For example, in March, 2011 statement of the total assets of People's Bank of China, “foreign currency" is listed as 22.6277 trillion Yuan. Using the average market exchange rate of 6.5695 Yuan/$, it becomes $3.444 trillion, whereas the officially announced foreign currency reserve in the month is only $3.0447 trillion. Why this difference? The officially announced number is calculated by adding up all the foreign currency at hand and converting them into Dollar at the prevailing exchange rates. This kind of calculation is called “mark to the market" method. The “mark to the market" method is not used in tabulating total assets of a central bank. Let us consider the following example as the illustration. Suppose People's Bank of China bought $1 billion at the exchange rate of 7 Yuan/$. This means that the central bank has given 7 billion Yuan to the seller of this $1 billion. The 7 billion Yuan issued by the central bank is recorded as its liability and $1 billion as its asset. What if the exchange rate moves to 6 Yuan/$? According to “mark to the market" method, the asset side now only worth 6 billion Yuan but the liability stay at 7 billion Yuan. Thus the central bank loses 1 billion Yuan and needs to reduce its capital by 1 billion Yuan. However, a central bank is not a commercial bank, and it never goes into bankruptcy because it exhausts its capital. So what it does is to keep the value of its foreign currency, at this example $1 billion, at the value when it was purchased, that was, 7 billion Yuan. This method of accounting is called “mark to the book" method.

The foreign currency component within the total assets of People's Bank of China in Yuan denomination, recorded using “mark to the book" method, just suits our purpose, since in one glance it tells us how much Yuan has been issued in the process of buying up incoming foreign currencies. This “foreign currency" component is plotted as the red curve in the first graph. The difference between the total assets and “foreign currency" is plotted as the blue curve that we call as “non-foreign currency" component. Non-foreign currency component is measuring the active intent of People's Bank of China when it comes to the monetary operations, that is, to ease or to tighten. The foreign currency component is just the passive reaction by the central bank since it has no control over how much foreign currency will flood in.

From the first graph we can see that only in earlier dates, non-foreign currency component is larger than the foreign currency component, but starting from 2004, the foreign currency component steadily outruns the non-foreign currency component. By the time at the threshold of the crash, the foreign currency component already counts more than 70% of the total assets of the central bank. During the crash the influx of foreign currency momentarily slowed down but it is picking up speed again as the global economy recovers. Also it is interesting to observe that during and after the crash, unlike its American counter part, the central bank of China has not actively printed a lot of money but let the amount of incoming foreign currency to dictate how much Yuan to issue. We may also say that the economic advancement of China is purely the result of the influx of foreign currencies since 2004.

3. Trade Surplus versus Hot Money

Once the influx of foreign currency is identified as the underlying force of pushing the rapid growth of China's economy as discussed in the previous section, naturally we want to know more about the details of this “foreign currency". An obvious factor that contributes to the influx of foreign currency is China's massive trade surplus. Other factors contributing to the influx of foreign currency is Direct Foreign Investment, and various other transactions and oversea profits. The most contentious factor of “hot money" is usually disguised as various other components and there is no such an independent listing called “hot money". We divide the influx of foreign currency into two categories, trade surplus induced influx and non-trade related influx. For monthly trade balance we use the publication by National Bureau of Statistics of China. Since monthly trade balance data varies widely from month to month due to the seasonal factors, we use 12 month moving sum to smooth out the data. We have also calculated 12 month moving sum of monthly difference of “foreign currency" component listed under “Total Assets of People's Bank of China". The difference between those two 12 month moving sums is called 12 month moving sum of “non-trade related" component. 12 month moving sum of trade balance is plotted as the red curve in the second graph at the right; this curve is plotted in linear scale in unit of billion Yuan. Similarly “non-trade related" component is plotted as the blue curve. The green horizontal bars are the year-to-year percentage changes of Nominal GDP expressed in percentages. We should note that year-to-year percentage change is roughly equivalent to 4 quarter (12 month) moving average.

The second graph shows that non-trade component of foreign currency influx has overtaken the trade surplus after the crash. It is also important to observe that the ups and downs of the green growth rate curve of Nominal GDP is more synchronized with non-trade component than with the trade surplus. Thus the non-trade related influx of foreign currency is more potent in shaping up China's Nominal GDP growth. This observation is rather unexpected and requires an explanation.

The incoming foreign currencies from both the trade surplus component and non-trade related component are sold to People's Bank of China, and the sellers receive Yuan in return. The difference between those two components is how the received Yuan is spent. For the case of trade surplus, most of the Yuan is plowed back to the manufacturing operation. As the money flows through the Chinese society, consumer spending is generated and is tabulated in the category of “personal consumption expenditure". Also the continuing exports are added to Nominal GDP in a separate category. Only a fraction of the Yuan received goes into the process of expand the manufacturing facility; this portion of the Yuan is tabulated in the category of “fixed asset investment" in Nominal GDP. On the other hand the majority of the Yuan received from the non-trade related component goes directly into fixed asset investment, like speculating on real estates or building factories and highrises. As has been pointed out in Comment 80, GDP doubles counts “fixed asset investment". Thus the non-trade related component has a biased influence on Nominal GDP.

4. Prognosis

With the analysis of the previous section in hand, we can now move to the prognosis about the course of Chinese economy. The two surges of the non-trade related component, the blue curve, in the second graph coincides with two bouts of Bernanke's quantitative easing, dubbed as QE1 and QE2.This implies that the majority of the foreign currency from the non-trade related component is actually the “hot money". What happened is as follows: When Bernanke floods the market with huge amount of dollar under the process of quantitative easing, the money has not flown into the hands of U. S. consumers because banks that have been burned severely by consumer default during the crash are reluctant to lend to consumers. A large block of money that Bernanke has created is borrowed by speculators to be brought into China and sold to People's Bank of China for Yuan. Thus “hot Dollar" is transformed to “hot Yuan". The “hot Yuan" then speculate on China's infrastructure construction and real estates that induces rampant construction of residential units. The result is the continued phenomenal growth of China's Nominal GDP.

Now QE2 has come to the end, and there is no QE3 in plan. Bernanke will still buy U. S. Treasuries, but only from the returning proceeds of maturing Treasuries. This means that though Bernanke will not withdraw the money injected into the financial market, he will not increase the amount of money injected into the market by any significant amount either. This implies that the amount of “hot money" flowing into China will just maintain its current size at best. Thus the blue curve in the second graph will stagnate and the growth rate of China's Nominal GDP, as expressed in the green bars in the second graph, will plunge. In order to counter the plunge, People's Bank of China probably will take back some monetary tightening tools installed earlier and try to sustain the growth rate of Nominal GDP at somewhere below 10%, in the meanwhile hoping that inflation will calm down somewhat so that inflation adjusted Real GDP will grow about 6% a year. However, monetary tools are blunt. Usually they are too timid to have satisfactory effect or too much to induce an unexpected havoc. It is very difficult to engineer a soft landing. We shall see what happens next.