Monetary policy under financial repression

Following Paul Krugman’s lead I guess I can refer to this post as being “wonkish”. Much of it is based on my recent book Avoiding the Fall (Carnegie Endowment, September 2013).

In order to understand much of what is happening in China I believe it is crucially important to understand how financial systems operate under conditions of financial repression. Because most of what we know about economics is derived from economists whose operating environment is the classical “anglo-saxon” economies (I stress “classical” because for much of the 19th Century, operating under the so-called “American System”, the US itself was not, in my opinion, a classic anglo-saxon economy), there is a tendency to assume that what happens in those economies is somehow the default position in economics, and this not only causes us to underrate important economists that don’t follow this tradition, like the German Freidrich List or the American Albert O. Hirschman, but it also leads us into mistaken assumptions, like the belief that higher interest rates lead automatically to higher savings rates.

We do know some things about financial repression. Two of the first important texts to discuss financial repression comprehensively are Edward S. Shaw, Financial Deepening in Economic Development and Ronald I. McKinnon, Money and Capital in Economic Development. There is, however, a lot more to it than what is generally known, and even this is largely ignored by most economists. It seems to me that many of the mistakes we make when we think about the relationship between cause and effect, for example the impact of monetary policy on China’s economy, arise because we assume that relationships that hold in the US economy are universal and must hold in the Chinese economy too. So to return to the assumption that higher interest rates must lead to higher savings rates, I would argue that this is true mainly under two unstated assumptions, neither of which holds for China.

First, higher interest rates must must have a negative wealth effect, which they mostly do in the US. In China however the wealth effect is positive. Second, changes in interest rates should have a minimal impact on the household share of GDP. In the US, where there is a wide variety of alternative investments and where interest rates move broadly in line with changes in inflation, this may be true, but in China where most households have few alternatives to bank deposits, and where interest rates are set independently of changes in inflation, this isn’t true.

In fact distortions in domestic interest rates may be the single most important explanation of why the household share of GDP has plummeted in China, especially over the decade ending around 2010-11. So while higher interest rates in the US are typically (although certainly not always) associated with increases in the savings rate, in China they are typically associated with reductions in the national savings rate. There should be nothing mysterious about these opposite reactions to higher interest rates – both are fully explainable with our current economic tools as long as we are clear about the assumptions, often hidden, that we  make. And notice that I refer to “national” savings rates, not “household” savings rates, which are commonly confused because in the anglo-saxon economies changes in the national savings rates closely follow changes in the household savings rate, whereas in China they do not.

To understand the Chinese economy we must understand how financial repression changes the relationships between variables, many of which we implicitly and incorrectly assume are fixed and permanent. Financial repression, in other words, is not only at the heart of both China’s rapid growth and China’s economic imbalances, but it also explains a number of otherwise puzzling aspects of the Chinese development model. A repressed financial system will seem to operate in a fundamentally different way than a market-based (“anglo-saxon”) financial system, but in fact the principles under which it operates can be explained using what we already know about the operations of monetary policy in a market-based financial system.

One of the apparent puzzles about China’s growth trajectory, especially in the past decade, is the seeming disconnect between rapid monetary growth and relatively stable domestic inflation. It is well known in economic theory that countries that have open capital accounts are forced to choose between managing domestic monetary policy and managing the currency regime.  When a central bank chooses to intervene in the currency to maintain a desired exchange level, the amount of money it creates domestically is largely a function of the need to monetize net inflows or outflows. On the other hand if it chooses to manage the domestic money supply, the supply and demand for that currency in the international markets will determine the value of the currency.

In China’s case the capital account is technically closed, so in principle Beijing should be able to manage both the value of the currency and the amount of domestic liquidity. In reality, however, there are two significant limits to the country’s ability to maintain closed capital accounts. First, and most obviously, the capital account is the obverse of the current account, and any country with the volume of exports and imports that China runs necessarily will see significant activity in the capital account, especially if, as widely believed, Chinese nationals evade capital controls by over- and under-invoicing exports and imports. What is more, although much of the trade-related capital inflow and outflow is controlled by the central bank, an increasing share of capital flows occurs outside the central bank.

Second, China has extensive trading borders, a great deal of local corruption, and a long history both of capital control and capital control evasion.  Throughout history countries with large trading borders, a long history of capital controls, and wide-scale corruption have rarely been able to control capital flows as these factors undermine the ability of financial authorities to manage them, and China is not an exception. In fact during the past decade by most accounts China has experienced significant amounts of both speculative inflows and capital flight, measuring probably in the hundreds of billions of dollars, neither of which is compatible with strict enforcement of capital controls.

For all practical purposes, in other words, and in spite of formal capital flow restrictions, China is also forced to a greater or lesser extent to choose between managing its currency regime and managing domestic money creation. Clearly it has chosen to manage the currency regime, and the enormous changes in central bank reserves, which at over $3 trillion are the largest hoard of central bank reserves ever amassed by a single country, are a testament to that.

Monetary expansion and inflation

Monetary policy from the point of view of the balance of payments is pretty clearly a consequence of the central bank’s need to monetize an enormous amount of net inflows. China’s current account surplus began surging around 2003-04 to levels that are almost unprecedented in history, with the country at its peak running a current account surplus of up to 10 per cent of China’s GDP, giving it, with the surplus equal to just over 1 percent of global GDP, one of the highest current account surpluses as a share of global GDP ever recorded.

The impact of the current account surplus on capital flows tended to reinforce monetary creation in at least two ways. As money poured into the country as a consequence both of its current account surplus and its net surplus on the capital account (among other things China is been the largest recipient of foreign direct investment in the world), it helped ignite a credit-fueled asset boom, especially in the real estate sector, that encouraged additional speculative inflows looking to take advantage of soaring prices.

In addition the massive current account surplus fueled speculation about the trajectory of the renminbi.  As investors expected the value of the renminbi to rise as it adjusted to current account inflows, even more speculative inflows poured into the country seeking to benefit from any appreciation. The result was that until late 2011 substantial net capital inflows, added to the already very high current account surplus, drove up central bank purchases to extraordinary levels. 

As a share of global GDP the only comparable hoard of foreign currency reserves occurred in the United Sates in the late 1920s, a period distorted by the destruction of much of Europe’s manufacturing capacity in World War 1 and by the impact political uncertainty in Europe had in driving capital to the relative safety of the United States. During this time, when the US experienced both massive current account surpluses as well as massive private capital account surpluses that generated its huge central-bank reserve hoard, the US share of global GDP was roughly three to four times the current Chinese share, which gives a sense of just how extraordinary the Chinese accumulation of reserves has been.

With so much money pouring into the country, the People’s Bank of China was forced regularly to monetize an amount equal to a substantial share of its existing money base. Normally central banks would try to sterilize this money creation, and the People’s Bank of China did try to mop it up, but most measures of money nonetheless continued to increase rapidly, and there is anyway a real question about the effectiveness of sterilization with highly liquid and credible instruments that are already a close substitute for money. The tools used to sterilize inflows, mainly short term bills issued by the central bank, are themselves forms of money, and the more extensively they are employed, the more liquid they become and hence the more “money-like.”

The alternative to a real and effective sterilization is for the Chinese economy to adjust in the form of a surge in inflation. As the money supply grows in response to China’s current account surplus and net capital inflows, it should cause prices and wages to surge, forcing a real appreciation in the currency, until both China’s current account surplus and net capital account inflows wither away. 

This is of course the classic currency adjustment mechanism under the gold standard. As reserves soared in China, money creation soared along with it. Rapid money creation should have resulted in a rapid rise in domestic wages and prices as demand for goods and services outstripped supply. Rising domestic prices should have in turn undermined Chinese exports, encouraged imports, and reversed capital inflows.

But this didn’t happen. In fact during the past decade, price inflation in goods and services in China has been fairly moderate, and usually driven exogenously (crop failures, high commodity prices, etc.) and wages actually grew more slowly than productivity. China’s export competitiveness not only was not eroded by domestic money creation, as it would have been under the classical adjustment mechanism, but it also had, by some measures, even increased during this period. There have been periods during which inflation seemed about to take off, but these periods tended to be short-lived and were always followed by sharp declines in inflation. 

At first this might seem to imply that sterilization was indeed effective in preventing money creation in China from getting out of hand. By selling central bank bills, transacting in the repo market, and raising minimum reserve requirements aggressively (to around 20 percent, compared to the 5-10 percent that is more common in developing countries), the central bank seems to have been successful in mopping up the money created by the monetization of current and capital account in flows and so protecting the Chinese economy from the normal consequence of maintaining an undervalued currency.

What happened, however, in fact was very different.  Generally speaking, there have been a number of countries besides China that have managed for long periods to combine tremendous capital and current account inflows, rapid growth in foreign currency reserves, and low inflation – for example Japan in the 1980s.  In nearly every case these countries also had severely repressed financial systems.

What’s more, although it was hard to find in China and other similar countries the normal evidence of rapid money creation in changes in consumer prices, other parts of the economy acted in ways that seemed consistent with rapid money creation. Credit, both inside and outside the formal banking system, grew astonishingly quickly and, as usually occurs under conditions of too-rapid credit growth, credit standards deteriorated. The stock and real estate markets experienced bubble-like behavior. Producer prices rose rapidly. Global commodity prices, spurred largely by soaring Chinese demand, also soared.

Bifurcated Monetary Expansion

So was Chinese monetary expansion excessive or not, or to put it differently, why is it that what seemed by most measures to be an extraordinary surge in money creation did not also result in significant wage and consumer price inflation? The answer, I will argue, has to do with the nature of money growth in financially repressed economies. Because the Chinese financial system is so severely repressed, money growth in China cannot be compared to money growth in a market-based financial system. Monetary growth is effectively bifurcated and affects producers and consumers in very different ways.

What does it mean to say that monetary growth was bifurcated? By this all I mean is that nominal money growth showed up as different rates of money growth for different parts of the economy. More specifically the rate of monetary growth for producers exceeded the rate of monetary growth for consumers, and this becomes clear by measuring the monetary impact on different sectors within the economy of monetary expansion under financial repression.

Countries with significant financial repression can experience periods of rapid monetary expansion with results that do not conform to normal expectations precisely because of this bifurcation in the monetary impact of credit creation.  On the production side of the economy it is easy to see in China over the past decade what looked like the consequence of rapid monetary expansion – rapid growth in credit, rising productive capacity, surging production of manufacturing goods, asset bubbles, etc.

On the demand side of the economy, however, and especially considering household consumption, one gets a very different view – monetary expansion seemed to have been very subdued. Household consumption typically grew much more slowly than GDP and its share of GDP declined steadily.  Consumer price inflation also tended to be low or moderate even in the face of what seemed like rapid monetary expansion.

So had there been too-rapid monetary expansion in China during the past decade or not?  Why do some sectors seem to indicate that there has been, and other sectors that there hasn’t?  The answer depends, it turns out, on which economic sector we examine, and whether that sector was a net borrower or a net lender.  We will see that financial repression can create a bifurcation in monetary expansion when

a)    net savers and net borrowers are two very distinct groups, in this case the former being households and the latter being producers of goods and infrastructure, including manufacturers, governments, real estate developers and infrastructure investors;

b)    the bulk of savings consists of deposits in the banking system and the bulk of corporate financing consists of bank lending or other forms of bank financing.

The experience of China (and other financially repressed economies) suggests out that when interest rates are set artificially low in such a financial system, any given nominal expansion in money supply creates a lower real expansion in money on the consumption side and a higher real expansion in money on the production side. The consequence may be rapid GDP growth, a surge in investment and low inflation for many years, but it also leads to sharply unbalanced growth in which the role of domestic demand as a driver of growth shrinks.

To see why, assume a country in which the “natural” nominal interest rate is 5% for all maturities.  For the sake of simplicity we will assume that deposit and lending rates are the same, and that the marginal reserve requirement is constant, although these assumptions do not affect our final conclusions in any significant way.

Now let us assume that there are immediately two transactions.  First, a saver deposits $100 dollars in the bank for one year at 5 percent and the $100 dollars are immediately lent out to a borrower for one year at 5 percent.  One year from now the borrower will repay $105 and the saver will receive $105.

Second, we assume that another saver deposits $97 for one year at 5% and the money is immediately lent out to a borrower for one year at 5%.  For the sake of simplicity we will round off the pennies and assume that in the second case the borrower repays one year later and the depositor receives one year later $102.

It is clear that the because of the first transaction the money supply has increased by $100, and the depositor will receive and the borrower will repay $105 in one year.  It is also clear that because of the second transaction the money supply has increased by $97, and the depositor will receive and the borrower will repay $102 in one year.

But now let us posit that the central bank decides suddenly and arbitrarily to reduce both the lending and deposit rate to 2%.  This has nothing to do with a change in inflationary expectations or the real demand for money – it is simply driven by other domestic considerations.

Following the decision a third, less fortunate saver decides to deposit $100 for one year at 2% and this $100 is immediately lent to a lucky borrower for one year at 2%.  Which of the first two transactions is closer in its monetary impact to the third transaction?

From the depositor’s point of view the present value of $102 one year from now is only $97 (for simplicity I am rounding off adjustments to the nearest dollar).  Although the nominal amount of his deposit is $100, just like that of the first depositor, the real value of his deposit is really only $97, just like that of the second depositor. If we define money so as to include deposits, did the money supply rise by $97 or $100? 

On a comparable basis it is pretty clear that the third depositor’s position, after interest rates were artificially lowered, is no different than that of the second depositor who deposited $97. Nominally the value of his deposit is the same as that of the first depositor, or $100, but his wealth is the same as that of the second depositor, or $97. Since it is real wealth, and not nominal deposits, that ultimately matters to the depositor, and which will affect his consumption and savings decisions, the third depositor is likely to behave over the long run as if he were in the position of the second depositor.  

Because in this case a $100 deposit results in a $97 increase in the real value of deposits, in other words, it turns out that the nominal growth in money as measured by deposits overstates the real growth. Under financial repression a $100 transfer from the household to the bank in the form of a $100 bank deposit results in a smaller real deposit than under conditions of no financial repression.

Transfers change the monetary impact

If financial repression distorts the balance sheet of the depositor, what does it do to the balance sheet of the borrower?  For the third borrower, who in our example borrowed under conditions of repressed interest rates, the transaction is the mirror opposite of the depositor’s transaction.  The third depositor effectively had $3 “confiscated” from his assets in the form of an arbitrary reduction in the deposit rate. This $3 is transferred automatically to the borrower, so that the third borrower’s liability more closely resembles that of the second bower, even though he receives upfront the same $100 that the first borrower receives. 

The nominal increase in money as measured by loans, in other words, understates the real increase. The third borrower receives both the $100 loan as well as a $3 “gift’ in the form of partial forgiveness of his debt.  His purchasing power has gone up not by $100 but rather by $103, even as the purchasing power of the third depositor has only gone up by $97.

Depositors in a financially repressed system may make the same initial deposits as depositors in a non-financially repressed system, and borrowers in a financially repressed system may receive the same initial disbursements as borrowers in a non-financially repressed system, but their resulting balance sheets are very different.  Wealth is effectively transferred from the depositor to the borrower under financial repression and so the purchasing power of the former is reduced relative to the nominal size of the deposit while the purchasing power of the latter is increased relative to the nominal size of the loan.

This transfer modifies the monetary impact on each of them and the effect is cumulative. Assume in the above example that the money supply consists entirely of $100 nominal of one-year deposits matched with $100 nominal of one-year loans.  If in any given year the money supply (loans and deposits) is increased by $20, or 20%, the impact on deposits and loans is very different. In effect the real value of deposits will have risen that year by only $2 (with $18 effectively transferred to borrowers), whereas the value of loans will have increased by $38. An increase in nominal money of 20% in other words, is associated with a 2% real increase in deposits and a 38% real increase in loans.

This is what it means to say that financial repression creates a bifurcation of monetary growth.  For households, and net depositors more generally, real monetary expansion is in effect much lower than nominal monetary expansion because of the implicit financial repression “tax”, and so consumption growth and consumer-price inflation will seem abnormally low.  For manufacturers, real estate developers, infrastructure investors and other net borrowers, real monetary expansion is in effect much greater than nominal monetary expansion because of an implicit financial repression “subsidy”, and so asset inflation and capacity growth seem abnormally high.

Perhaps one way of thinking about it is to consider how to make a comparable impact in a market system.  Imagine if somehow the US were to enact a law whose result was that every time the Fed expanded the money supply, a one-off tax was imposed on households, the proceeds of which were transferred to corporate borrowers. In that case monetary expansion would be much less likely to cause an increase in demand for consumer products, and so would create much less consumer price inflation, and much more likely to cause a surge in production.

This effective “tax” suggests that in a financially repressed system, it is normal that the impact of nominal monetary expansion will seem much greater in one sector of the economy than in another, with the differencing reflecting the net lending or net borrowing position of that sector. The impact of monetary expansion on the behavior of the saver is much lower than it is in a market-based financial system, all other things being the same. The impact of monetary expansion on the behavior of the borrower is much higher than it is in a market-based financial system, all other things being the same.

Under these conditions it is consequently not surprising that the economy can seem to be operating under conflicting monetary systems.  Consumption behaves as it would in an economy with much lower monetary growth, and production and asset prices behave as they would in an economy with much higher monetary growth.

I will leave it to an ambitious doctoral student to work out the full monetary implications of financial repression and to formalize a model of monetary growth under financial repression, but it is worth noting that there are several other real implications of this bifurcation in monetary policy, all of which seem to apply to the Chinese economy:

a)    Financial repression creates in effect a two-speed economy. There will normally be a growing imbalance between the net saving and net borrowing sides of the economy, and the latter should grow much more quickly than the former. 

b)    By subsidizing the production side of the economy and penalizing the consumption side of the economy, financial repression must always force up the domestic savings rate. This may seem at first counterintuitive because, as I discussed at the beginning of this entry, we normally associated lower interest rates with lower savings, but it is an automatic consequence of the very different wealth effect that changes in interest rates have on market-based financial systems and financially repressed financial systems. Savings, after all, are simply the difference between consumption and production, and any process that forces production to grow more quickly than consumption automatically forces up the savings rate.

Financially repressed systems with artificially low interest rates tend historically to have much higher national savings rates than market systems, and also much higher savings rates than financial systems in which interest rates are abnormally high, but oddly enough the higher savings rates are almost always ascribed to cultural preferences. Rather than explain differential savings rates by cultural factors, it seems far more promising to explain them as consequences of financial repression.

c)    To rebalance the two sides of the economy either policymakers must eliminate, or even reverse, the transfer created by financial repression (i.e. either nominal interest rates must rise or GDP growth must drop) or they must implement another mechanism that directly transfers wealth from net borrowers to net lenders.

d)    The more interest rates are repressed, the harder it is for consumption growth to keep up with production growth because monetary policy driving consumption is effectively much “tighter” than monetary policy driving production.

e)    Consumer price inflation is not the appropriate measure by which to gauge domestic monetary conditions.

f)      Hikes and reductions in interest rates are not expansionary or contractionary in the way we might expect in an open financial system.  A hike in interest rates may act to contract investment, but contrary to conventional wisdom it actually expands consumption because it reduces the wealth transfer from the saver to the borrower.  This allows the saver to increase consumption.

g)    For the same reason consumer price inflation in a financially repressed system can be self-correcting.  If inflation rises, but interest rates do not, the bifurcation of monetary growth will increase because the difference between the “correct” interest rate and the nominal rate increases.  In that case any given nominal monetary expansion is accompanied by an even lower (or negative) real expansion from the point of view of consumers as net savers. By lowering the real cost of credit for borrowers, it can expand production.  Increasing production while reducing consumption, of course, puts downward pressure on prices.

h)    Monetary expansion accelerates investment and asset price inflation.  If inflation rises, but interest rates do not, any given nominal monetary expansion is accompanied by an even greater real expansion for net borrowers.

i)      This may be why in financially repressed economies regulators often resort to formal or informal loan quotas.  Without loan quotas, monetary expansion for borrowers may far exceed the needs of the economy, even as monetary expansion for depositors is too tight.

j)      As long as the rest of the world can accommodate the consequent excess of production over consumption, the bifurcation in monetary policy will not seem to be a problem, but once the world cannot accommodate it, the bifurcation of monetary expansion will create deflationary pressures.

k)    As long as the rapid increase in monetary expansion for borrowers does not result in a misallocation of capital, the bifurcation in monetary policy will not seem to be a problem, but once rapid money expansion leads to increasingly wasted investment, as it eventually always must, the bifurcation of monetary expansion will create asset inflation and an unsustainable increase in debt (as debt rises faster than debt servicing capacity).

l)      Deflation or disinflation partially or wholly resolves the bifurcation by forcing real interest rates towards their “correct” level (because real deposit and lending rates rise in a deflationary environment in there is no change in the nominal interest rate).   Under deflation we would expect to see the gap between consumption growth and GDP growth narrow, or even reverse.

m)  Slower GDP growth partially or wholly resolves the bifurcation by forcing real interest rates towards their “correct” level (in a market system nominal interest rates move naturally in line with nominal GDP growth). Under conditions of much slower GDP growth we would expect to see the gap between consumption growth and GDP growth narrow, or even reverse. This, for example, is what happened in Japan after 1990.

n)    Disintermediation of the banking system, to the extent that it reduces the impact of financial repression, may create an unexpected burst in consumer price inflation. This is less true to the extent that, like in China, disintermediation is limited to the rich, since the consumption impact of higher income on the rich is limited.

Asset price inflation

To summarize, in a financially repressed system in which consumers tend to be net savers and producers net borrowers, consumers and producers experience very different monetary impacts of the same underlying monetary conditions. The latter exist in an environment in which the impact of monetary growth is much faster than do the former.

There are two problems, then, which must arise when a financial repressed system experiences long periods of rapid money growth. First, as growth in production systematically exceeds growth in consumption, absent exponential growth in investment a growing trade surplus is necessary to resolve the growing imbalance.  Once there are constraints on the ability of the trade surplus to continue growing – for example the global financial crisis has caused a collapse in the ability of the rest of the world to absorb China’s rising trade surplus – the only way to prevent a collapse in growth is to increase investment even more.

But if investment is being misallocated this simply exacerbates the second problem.  Rapid monetary expansion, exacerbated by the bifurcation created by financial repression, has a tendency to result in capital misallocation and asset price inflation because it accelerates monetary growth.  If the response by policymakers to a contraction in the world’s ability to absorb rising trade surpluses is to engineer a further increase in investment, we would expect debt to surge, more investment to be wasted, and for the debt consequently to become unsustainable much more quickly.

This seems to be exactly what happened in China during the 2008-09 global crisis.  Before the crisis, debt was already rising at an unsustainable pace thanks to many years of the combination of rapid monetary growth and monetary policy bifurcation.  China’s trade surplus also soared as production was forced to rise much more quickly than consumption.

The crisis caused a collapse in China’s trade surplus.  In order to limit the impact on Chinese growth, Beijing engineered an extraordinary increase in domestic investment.  What is more, Beijing increased both the total amount of loans and deposits outstanding while lowering even further the real interest rate.  The net impact was to increase the financial repression tax on households – a tax which when directly to subsidizing borrowers. 

This certainly resolved the problem of a sharp decline in growth caused by a collapse in the trade surplus, but it did so by exacerbating the investment bubble and accelerating the rate at which the growth in debt exceeded the growth in debt servicing capacity.  It also worsened the consumption imbalance. It is probably not a coincidence that it was only in 2010 that most analysts belatedly recognized the problem of soaring debt in China – probably at the instigation of a report by Victor Shih, then a professor of political economy at Northwestern University and until then one of only a handful of China skeptics, on the surge in local and municipal debt.

As Chinese growth rates stayed high even in the midst of the worst global economy in 70 years – a fact that was a necessary consequence of the combination of increasing financial repression and a surge in monetary growth – there were always likely to be two factors that would undermine growth.  First, if the pace of monetary expansion slowed, and second, if the financial repression tax declined. 

What does it mean to say that the financial repression tax declines?  This doesn’t simply mean that interest rates rise, but rather that interest rates rise relative to GDP growth.  In a market-based system, over long periods of time nominal interest rates are broadly in line with nominal GDP growth rates. This means that savers and borrowers fairly distribute the returns on growth in proportion to the amount of risk they take. Of course if interest rates are artificially low, savers receive a disproportionately lower share and investors a disproportionately higher share of the benefits of growth.

The greater the difference between nominal lending rates and the nominal GDP growth rate the greater the financial repression tax. In China during the first decade of this century nominal GDP growth rates have been 16-20%, depending on which period you measure and what assumptions you make about GDP growth, while nominal interest rates have been roughly 6-7%.  This gives some idea of the extent of the financial repression tax, although even this understates its extent because the spread between the lending rate and the deposit rate is set artificially high, thus lowering even more the returns to depositors (an additional tax is effectively levied on depositors to recapitalize the banks).

The important point is that beginning sometime in late 2011, both conditions were in place.  As debt continued to rise in China and as slowing growth eroded China’s trade surplus, there is evidence that beginning in 2010 capital flight from China began to surge, while beginning some time in the fourth quarter of 2011 speculative inflows into the renminbi began drying up. The combination turned China’s position from running net capital inflows to running net capital outflows (excluding changes in central bank reserves, which by definition balance out total flows to zero).

As a result, in late 2011 and 2012 we witnessed for the first time China’s reserves rise by less than the already-much-lower current account surplus. By the middle of the year, net capital outflows actually exceeded the current account surplus (reserves, in other words, declined in spite of a current account surplus).

As Chinese money creation slowed, exacerbated by monetary bifurcation, Chinese growth slowed along with it.  This had the impact of reducing the financial repression tax (the difference between nominal GDP growth and nominal interest rates narrowed).  The consequence was predictable.  GDP growth slowed far more quickly in 2012 than even the pessimists had expected.

This is part of the self-reinforcing tendencies that financial repression creates for an economy. Rapid growth increases the financial repression tax, which tends to create even more rapid growth by reducing the real cost of capital. Slowing growth reduces the financial repression tax, which slows growth even further. These self-reinforcing tendencies imbedded in the national capital structure are typical of developing countries and one of their great sources of economic volatility – one that tends to undermine long-term growth.


This is an abbreviated version of a chapter of my recent book (Avoiding the Fall) which itself came out of one of my newsletter several years ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.



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  1. Prof Pettis – another excellent and clear article, however there was one paragraph i didn’t follow:

    “Assume in the above example that the money supply consists entirely of $100 nominal of one-year deposits matched with $100 nominal of one-year loans. If in any given year the money supply (loans and deposits) is increased by $20, or 20%, the impact on deposits and loans is very different. In effect the real value of deposits will have risen that year by only $2 (with $18 effectively transferred to borrowers), whereas the value of loans will have increased by $38. An increase in nominal money of 20% in other words, is associated with a 2% real increase in deposits and a 38% real increase in loans.”

    In the example, the natural rate of interest was 5% and the official rate was 2%, so i would have thought that a 20% increase in money supply would lead that year to a 19.4% real increase in deposits (ie 20*1.02/1.05) and a 20.6% real increase in loans. How do you arrive at the 2% and 38% figures?


    • Thnaks, Pat, and the difference probably arises because I am looking at the impact on the full amount of loans and deposits outstanding.

      • Prof Pettis,

        pardon me, I still don’t understand your answer to Pat’s well argued question. Would you mind clarifying the formula and inputs you use to reach 2% and 38%?

        I think a clear answer to this point would substantially strengthen your conclusions at least in my mind.


    • Pat,
      I guess “loans creates” deposits” but do not forget about the “moneymultiplier” in i.e shadowbanking-systems and the normal bank-repomarkets(rehypothecation and centralbank-interventions) which “multiplies” even more during financial repressions, aka negative real interest-rates.

    • Deposits t(0) $100
      Deposit Rate 2.0%
      Deposits t(1) $102
      Money Supply Growth YoY 20.0%
      Change in Deposits due to Money Supply Effects t(1) $120
      Difference in Deposits due to Interest Rate and Money Supply Growth $18
      *^ ‘Transferred’ to Borrowers due to financially repressed rate for depositors; the rate the depositors are paid is lower in real value than the level their income / deposits / value would rise due to money supply / inflation hence their is a transfer of wealth*
      Total Borrower Fund Available (Increase in Loans + Deposits Available) $38
      Real Interest Rate -15.0% (= -$18/$120)
      ^** Represents a transfer of wealth from the depositor to the borrower

  2. MP- interesting essay. I follow your descriptions of the money pathways and repressive tax on consumption, but don’t all countries to a greater or lesser extent distort the free allocation of capital? Even the Anglo-Saxon model is confusing mess of taxes, regulations and subsidies. Only when countries are young, and wild does the entrepreneur have the ability allocate capital purely on commercial grounds.
    My question is as follows: if a country wants to “avoid a fall” ( i am inducting from your title), then does it matter less how repressive its interest rates (and fiscal policy) distort capital allocation and does it matter more how flexible the system is when the crisis or collapse happens? The structural issues in china (or Japan, Greece etc) leading into the fall matter less than the flexibility of the political economy to re-adjust in a meaningful way. Countries with a capital surplus have more capacity to suffer in a crisis, but if they can re-adjust quickly (maybe singapore?), then they can prosper and grow after a short period of adjustment.

    • Yes, Scott, nearly every economic system implicitly contains a number of factors that “distort” the free allocation of capital. In fact I am not even sure there is such a thing as the “free allocation” of capital because allocating capital requires a financial system, and any system will have institutional constraints that affect the way capital is allocated. I think we shouldn’t assume that to “distort” the allocation of capital is somehow to make things worse than they might otherwise have been. Distortions can be both good and bad for growth, depending on the circumstances. So, for example, I would argue that in the 1990s China’s system of financial repression was exactly what it needed in order to close the gap between its actual (low) level of investment and its optimal level of investment as rapidly as possible. It only became a serious liability once that gap had been closed.
      I think more generally we have a tendency to think that any specific policy is either good or bad in itself, when in fact it will be good under certain circumstances and bad under others. So inevitably when someone like me points out that financial repression has created costs for China, someone inevitably (and indignantly) will deny the claim by pointing out that the US is experiencing a form of financial repression today.
      This is a little like refusing to give a starving man cake on the grounds that a man on a diet shouldn’t eat cake. The circumstances matter.
      That is a bit of a digression, but to get back to your comment, yes, financial flexibility matters a great deal, not least because in a very flexible system significant imbalances are less likely to persist over long periods than they are in an inflexible financial system like that of China.

    • Free and distorted are convenient terms but misleading in that “free” implies omniscience and distortion implies any deviation therefrom. If there was a way to impute future regulatory burdens and tort claims based upon science that can only be developed from monitoring the waste streams of future technologies we would be well on our way to freer markets.

  3. It seems that this financial repression tax stems from Chinese policy makers lowering interest rates despite an absence of deflationary pressures. Is this why the negative real rate environment in the US has not levied a similar tax on consumers? Because without ZIRP and open market operations the US would face deflation?

    • Then Fed wouldn’t have to force airport and it would happen on its own. Fed forcing means rates likely are lower than natural rate. It must be repressionary, therefore.

    • I think there is less of a financial repression tax in the US mainly because US savers have a much wider array of investment alternatives, and can opt out of highly negative deposit rates.

      • MP-

        Thank you for this article. It helps explain the financial repression tax and lays strong groundwork for a non-“anglo-saxon” interpretation of economies and economics. What do you think of Austrian vs Complexity Eco?

        In the comment above, I believe the operative word is “less” and notably not zero. In fact, I posit that there has been a financial repression tax in the USA for a very long time — since the 1980s, at least. So long that, in fact, it is the implicit norm hence not taken into account. As a teacher (working joe) I have become an economic refugee from the USA for this very reason. Every years since the 1970s it’s been one step forward and a few inches back, year after year.

        Looking forward to your reply.


        • Thom,
          May I comment on Your observation! I think there is a positive correlation between lower domestic investment-growth and stagnant real wages since the 80’s. Leading this force are US Big(ger) Corp and their wage-arbitrage(more consumtion less production). Deflation is rising which means relatively more problems for smaller companies(employment-base in the US).

          • Thomas and Christer, while you might be correct about the impact of rising income inequality and stagnant wages, it does not have anything to do with a financial repression tax. As Mr. Pettis has said many times, the U.S. does not have a financial repression tax simply because it is very easy to invest savings, even small amounts, outside of traditional low rate bank deposits.

  4. why Fed’s policy to keep rates low be considered as a financial repression as well, even though US is a developed economy? And rising domestic rates must be inevitable if China is on the path of rebalancing. However, if inflation in US picks up then China c/a balance can strengthen again and extend the life of current distortions.

    • I don’t think financial repression has to do with whether an economy is developed or not, LS, but rather whether there is a gap between the nominal GDP growth rates and the relevant lending rate, and whether borrowers or savers have alternatives to the banking system. At any rate I think the main problem with financial repression in China is not the current account but rather the addiction to cheap credit and the low household share of GDP.

  5. This helps explains the perchant for luxury apartment investment/sepeculation as mid-high income families with a surplus try to shift from being on the consumer side to benefiting from the producer transfer under the repressive regime. What this does has some practical outcomes
    – lower income families are locked out from private ownership as prices inflate
    – oversupply (and under-utilisation) of luxury segment as compared with more affordable housing
    – perverse construction incentives as if the response to buying is via interest rate manipulation, building to flip to take advantage of short-term sentiments impact on quality (I’ve seen closeup the shoddy brickwork hidden behind a fancy facade …. see story of collapsing building in Shanghai)

    Wondering if this will end up leading to legislative capture as in HK where the construction industry and the Legco has had long-standing ties (many HK tycoons built initial wealth on development). This has important ramifications if/when Beijing attempts to unwind the repression to find alternative fixes.

  6. What you are describing for China is also happening in the US where, under open ended QE, money supply growth has been faster than the nominal growth rate of the economy, yet inflation has slowed and the trade deficit has been reducing. From the latest flow of funds accounts, you also see that the business sector continues to releverage while households continue to deleverage.

    Two questions if i may:

    1) if your analysis is correct, how do you understand then that the Fed is now indicating that it will continue QE until a certain unemployment and inflation threshold is reached?

    2) what happens when the largest countries / economies in the world follow this same strategy simultaneously, as is now the case with China, the US, Japan? Seems to me that this will lead again to overcapacity in several industries globally, to deflationary pressure, possibly affecting debt servicing capabilities. Is it not where we were just 5 years ago?

    Thank you

    • Again, DvD, I am very hesitant to read the same consequences of financial repression in the US as in China. Their causes and consequences are dramatically different. With QE the Fed is responding in the classic way to the perception of weak domestic demand, and remember that the wealth effect of QE in the US is in some ways the opposite of the wealth effect of QE in China. It does seem to me however that you are right to worry about QE being the policy in every major economy. Frankly I see QE as a form of currency war, even if it is usually not intended as such.

      • Professor, I do think global-wide QE is very different than currency wars. Global-wide QE will increase the global money supply across the major economies to help adjust and absorb the global overcapacity. I am not sure if Bernanke said it specifically, but his intent was to spur the Germans and Japanese to loosen their monetary policy. Even if the Germans and Japanese intended effect was to prevent currency appreciation vis-a-vis the Dollar by QE, the incidental effect would be they were stimulating domestic demand. We all know from your readings that German and Japanese trade deficits have a serious negative impact on global demand and the global economy.

      • Great article for putting the topic of financial repression squarely on the table.

        I disagree with this.

        “Again, DvD, I am very hesitant to read the same consequences of financial repression in the US as in China. Their causes and consequences are dramatically different.”

        Yes, the consequences are dramatically different, but the causes are human nature based and exactly the same.

        If one looks at the past opium wars in China one will see that this is the same ‘war’ of oppression being played out in the present with credit rather than opium being ‘pushed’ into the economy. The oppressive causative methodologies are the same but the consequences are dramatically different relative to historical setting. We also see that there is always too much emphasis on the consequences and far to little on the root human nature based causes.


        “Same wars, different drug…
        The Opium Wars in China were milestone events in the nation’s history. Great Britain, in a move to repatriate silver that was being spent for tea (there was a high demand for tea in Britain and only silver was accepted in payment by China), and at the same time to subjugate the Chinese people, introduced the recreational use of opium mixed with tobacco products. This resulted in the opium wars of 1839–1842, and 1856–1860. These wars ended in a victory of the Western powers over China resulting in the Treaty of Nanjing and the Treaties of Tientsin. Hong Kong Island and southern Kowloon were also ceded to the United Kingdom.

        Four items are worthy of note here;

        1. The opium laced tobacco products in and of themselves did comparatively little harm to the nation.

        2. The greater harm was in tearing, fragmenting, and degrading the social fabric of China as many Chinese citizens joined in on the deceptive subjugation of their fellow countrymen for profit by pushing these drugs. This was in reality a manifestation of the growth of the sociopathic disease of Xtrevilism as it infected many Chinese citizens and resulted in a weakening of their national alliance.

        3. The opium wars also resulted in the “Self-Strengthening Movement” which drastically changed the direction of the country and further strengthened the spread of the infection of Xtrevilism. From Wicki;

        The majority of the ruling elite still subscribed to a conservative Confucian worldview, but following China’s serious defeats in the First and Second Opium Wars, several officials now argued that in order to strengthen itself against the West, it was necessary to adopt Western military technology and armaments. This could be achieved by establishing shipyards and arsenals, and by hiring foreign advisers to train Chinese artisans to manufacture such wares in China. It was believed that the intelligence and wisdom of the Chinese civilization was superior to those of Western “barbarians”, and thus China would first learn from foreigners, then equal them, and finally surpass them. As such, the “self-strengtheners” were by and large uninterested in any social reform beyond the scope of economic and military modernization.

        The “Self-Strengthening Movement” also represented another wedge in the social fabric of China as not all of the elite were in agreement with the policy of diverting valuable resources to military technology and armaments. This also caused further weakening in the unity of the national alliance.

        4. All of the above took place when information flow was at a snail’s pace (compared to today) and changes were made very slowly.”

        More here;

        Deception is the strongest political force on the planet.

  7. Another excellent analysis. Professor Pettis, you are the best expertise on China. Thanks.

  8. To what extent would an improving global capacity to absorb Chinese over-production mute the impending strains? If that capacity were “big enough” Beijing could shift monetary growth from over-investment back to over-production, while keeping its financial repression. And that might actually help make un-productive investments slightly less bad – and maybe even sustainable, if global demand surges.

    Which is to say that every step to rebalance China does NOT take is an implicit bet on surging global demand…a bet europe and japan seem to be making. Now that’s a crowded trade!

    • China saved the asian tigers by absorbing their production, but there is no new developing country big enough to absorb china’s production, Africa? India? central asia? not likely.

  9. QE: The greatest subsidy to the rich ever?
    Stanley Druckenmiller, the billionaire founder of Duquesne Capital, called the Fed’s policies “the biggest redistribution of wealth from the middle class …

    • Yes, I worry that QE is exacerbating income inequality, and this may be the biggest problem the world faces just now. Ignoring the social and political implications of income inequality, which are bad enough, we need to remember its impact on growth and unemployment. Wealth consists of all the goods and services produced. As wealth is concentrated, it causes a reduction in consumption because the rich consume a smaller share of their income than the poor. It also causes a longer term reduction in investment to the extent that investors believe the reduction in consumption is permanent — the purpose of investment today is to serve consumption tomorrow.
      This means that rising income inequality causes a mismatch between all that is produced and all that is consumed, and if the former exceeds the latter, the only resolution is either to get households to borrow money to consume more (a temporary solution) or to produce less (fire workers). We have seen both of these occur over the past decade.

      • Prof. Pettis,

        What about these massive fiscal deficits we’re seeing across the world? I’m way more worried about the fiscal situations of the countries in the developed world than I am about QE primarily due to the nonlinearity of debt servicing costs to tax revenues when government debts are much, much larger than tax revenues. Due to the ZLB, many countries fiscal situations look better than they actually are. Also don’t forget that most of the developed world will be entering a secular shift in demographics as well, which will create problems down the road. At what point will the currencies start to show some pressure. I have a major worry that the entire world is becoming Japanese in the sense of massive government debts that we can’t grow out of. Rather than doing the sensible and right thing, which is to liquidate bad debts, governments are just taking bad private debts onto their balance sheet and using BS accounting along with extremely low interest rates to make everything seem stable and fine. It seems to me like we’re just seeing massive amounts of volatility suppression.

      • I am very glad you said this Professor. I had a hunch these were your leanings with regards to political economy. This is a serious problem in the U.S. that the Republicans can’t understand. (PS- I am a moderate Republican.) The Democrats over-simplistically blame Reagan trickle down economics. I get tired of dunderheaded commentators on CNBC, Bloomberg and Fox Business News chirp the simplistic mantra that we have to encourage savings and investment in the U.S. when we are awash with capital and no demand.

        It’s very clear income inequality in the U.S. is stymying the recovery. This has built up over the last twenty-five years and was masked by credit expansion until 2008. There is no denying this. I don’t entirely agree with either the Republican message of lowering taxes and incentivising investment or the Democratic message of increase taxes and redistribute wealth. The reasons behind this increase income inequality in the U.S. are many and complex. First and foremost, I do think competition with cheaper foreign labor has decimated the working class pushing many of them down into the lower class. Government and union jobs (what’s left) are the only refuge for those with limited skills and education. I’m not saying I would increase government jobs. I also have mixed views on unions. Minimum wage increases by states and local governments are in effect a state or city-wide wage negotiation. I don’t want massive government programs that create unproductive jobs or ineffective job training. I do think consolidation of economic power across many industries has put pressure on the middle class. Banking is a perfect example where government policy as far back as the 1990s to increase bank consolidation has eliminated hundreds of thousands of skilled, middle class positions. I will forgo any discussion of too big to fail policies which are another matter that likely promote income inequality.

    • Asset price inflation is a transfer of wealth from young gen Y to the boomers. It allows the boomers to flip their over-valued house to young gen y suckers. Most of boomers’ saving is not in their savings account, but in the value of the house they live in. Gen Y get the debt so that boomers can preserve their savings.

  10. Do you think that current tensions in the Chinese interbank market mean that the current financial repression and the resulting debt-financed over-investment have run its course? If so, what´s next? Can domestic consumption rise fast enough to absorb the slack?

  11. Michael,
    Thank you for the depth of insight and the power of explanation. I have been reading your blog for about 12 months and just read ‘The Great Rebalancing’. I want to read your material further but have a clear need to understand the fundamentals of world trade, finance, capital movement etc. What actually happens when I buy a foreign currency? How does a Chinese exporter actually get paid in Remnimbi when they receive US dollars in the States? Etc. Can you recommend a book or article that gives a simple explanation? Have you written something appropriate?
    Bruce Morrison

  12. Hi Michael,

    Just out of interest, who are the other China commentators that you respect the most? It would be really interesting to hear

  13. If tensions in the Chinese interbank market signal that over-investment has gone too far and that over-stretched borrowers or their lending banks need to be supported, it becomes even more difficult to gradually remove financial repression in the form of gradually higher interest rates. Looks like it has the potential to turn into a vicious circle.

  14. Dear Micheal,

    Great to see that you can still shed new light or perspective on an issue that you have been writing about for 7 plus years.

    I have a question. It would seem that financial repression has a somewhat limited scoop with regards to where it can inflate capacity. The main sector being real estate, manufacturing and low to medium tech export related industries.

    If this is true then a financial repressed economy should have a lack of capacity in food production, service related industries and the financial sectors. If one looks at China it would seem that all these industries or sectors are lacking investment and development. It is also the industries that are closed off to FDI.

    My question is if this is normal for all economies that have based their growth on financial repression? If so it would seem the growth model of financial repression is the first step into dependency on the international market as the possible of servicing and feeding ones population becomes dependent on foreign markets.

    Many thanks and happy New Year

  15. In sum, negative real interest rates are bad for savers and good for borrowers ceteris paribus. If households have few alternatives to saving other than bank deposits, then a negative real rate is effectively a tax on households to fund a benefit for borrowers. That being said, the economy is of course a very complicated machine with lots of moving parts. Negative real rates, particularly one that is below the natural (or equilibrium) real interest rate is also highly stimulative for the economy. And the resulting economic growth should broadly benefit both households and corporate borrowers. So households can also derive benefits from a negative real rate in terms of income rises and low unemployment, which may (or may not) counteract the implicit tax on their savings. Of course, corporate borrowers benefit more and from both channels, through cheap borrowing and higher revenues from econommic growth. But the system as a whole may not be entirely a net negative for households, unless they also derive very little benefit from broader economic growth.

  16. I’m not an expert on the Chinese economy, but I remember reading somewhere that it is the Chinese corporate sector that has largely driven the national savings rate higher over the last decade. Do correct me if this information is wrong. If it is right, then are the corporates borrowing money from the banks different from those saving money with them? How would you account for rising corporate sector savings in your paradigm?

  17. @AT
    My understanding is that corporate savings corresponds mainly to the autofinancing part of their investment through retained cashflows, not so much to their depositing rising cash balances in the banking system. Net corporate borrowing corresponds to the portion of corporate investment on top of what can be self financed trough retained cashflows.

  18. We should always carefully analyze to Prof Pettis words and always consider in relation to his model. When one inserts -3% in interest calculator,
    one obtains 63% after 15 years and 86% after 5 years. This shows that after 15 years 37% of GDP is transferred from household sector. So when AT says that household derive a benefits from a negative real rate, it is true if this negative real rate is short but it is not true if it is prolonged and then the years of stagnation say 10-12 years are included.

    As to statement that SOE in China saw rising savings, it is true because there is no difference between national savings and SOE savings.

  19. Michael, the China foreign currency reserve of 3.66 trillions USD must be good for something during the painful re-adjustment of their economy. How do you see the Chinese government plan to use that reserve to help with the re-balancing?

    • Is it not the case that China monetary reserves have already been used, not once but twice?

      Once, they have been on-lent to the US (mostly) as the reciprocal of the Chinese trade surplus vis a vis the US during 2001-2008, helping keep US interest rates low and thus helping US consumers borrow to consume made in China products despite rising under-employment and increasing wage pressure and facilitating the wealth effect dear to the Fed in the form of the real estate bubble.

      From 2009, the reserves forming the monetary base of China own domestic fractional credit system, have been used to finance the gigantic stimulus program of 2009 via a dramatic credit expansion that has remained far in excess of nominal economic activity ever since, resulting in a material deterioration of overall leverage levels whose symptoms are the current tensions in the interbank funding market.

      This is the double credit spiral, described by French economist Jacques Rueff in the early 1970’s already, which is at the heart of the dysfonctional world monetary system where debt are allowed to build upon other debt in an ever more fragile pyramid.

      • That’s correct in the last few years but I am trying to understand policy for the future. As Prof. Pettis pointed out in his article “Hidden debt must still be re-payed”: …. it makes sense, I think, to repeat why central bank reserves cannot in any way help China resolve the crisis……

        I just wonder if there is a way China can use its huge foreign reserve of 3.66 trillion USD to resolve the crisis this time – not as the only solution, but as part of a solution.

        • You can leverage them even further by extending even more bank credit out of them. Not that it would helpl (would most likely make things worse) but certainly doable.

  20. Michael in my opinion you make it too complicated. The simple story of economics is that top-down control (i.e. government) leads to massive failure.

    We are headed to massive repression because people don’t understand this. Socialism (top-down control) is peaking.

    This repression will force people into chaotic strategies in order to survive.

    Past detail on simulated annealing, etc from your lost blogs is here:

  21. Hi, I just compared the rates of growth in the CPI and PPI series published by the National Bureau of Statistics of China, and found little difference when comparing CPI with the PPI for Industrial Products (there was a difference when compared with the PPI for Industrial Producers). I was wondering how this reconciled with your theory of monetary expansion affecting cetain sectors of the economy more than others (shouldn’t it show up in PPI data), or is it just a matter of data quality, in which case how can your theory be verified? Thanks for any advice you can give

  22. A very nice synthesis of the lessons learnt from the Volatility Machine AND your later books.

  23. China’s financial reforms are probably not going to make the yuan fully convertible anytime soon. China’s Politburo still believes it can force foreign investment into sectors that favor long-term development priorities. The foreign trade zones are part of this experiment:

  24. Prof Pettis – it seems the only difference between financial repression in the US compared to China is the ability of Americans to invest abroad. The plethora of Wealth Management and Trust products in China in their diversity surely fill most of the investment opportunities available in the US.

    The net result therefore of an unwinding of financial repression in the US on this basis would be an unwind of foreign investment, I.e. Reduction in investment to largely EM (given most of DM is similarly financial repressed)? On this basis and given market reactions I think your thinking on financial repression is even more pertinent in the US. Huge asset bubble, stagnant households, greater weather inequality, inability to generate inflation, etc etc.

    It seems somewhat odd, yet logical that higher interest dates means higher inflation and higher wages. Surely on the basis of your thinking the Fed has got it completely wrong?

    You seem a tad dismissive of your thinking applying to the US – in fact I think you are spot on.

    How does financial repression end? Raising rates, but what will force the hand of policy makers to reverse direction? This us where the money to be made lies in my opinion. Very interested in your thoughts here.

    Best regards.

    • We don’t have an inability to generate inflation. You can always generate inflation: print money to run deficits and inflation will take off.

      Higher short term interest rates do not mean higher inflation here in the US. To raise interest rates means to contract the base money supply, which is the amount of reserves in the banking system. If you contract the amount of reserves of the banking system sharply, banks will be forced to contract their balance sheets and it will lead to a depression in today’s economic environment. You’ve got the causation backwards, higher inflation leads to higher longer term rates. As the yield curve steepens, inflationary pressure increases (assuming default risk is negligible) so central banks are forced to raise short term interest rates (i.e. reduce bank reserves) to keep inflationary pressure in check. Also, don’t forget the present value effect of raising short term rates on asset values.

      The problem with applying the logic of this post to the US is because the US and China are structurally completely different economies. The US is a deficit country that had a massive consumption boom while China is a surplus country that’s in the middle of a massive investment orgy. Negative real interest rates drive up the savings rate, which is what a country like the US needs while China has extremely high savings rates and needs to drive up consumption.

      • Actually you can’t always generate inflation, you may have come across something called a democracy – its a concept whereby people vote in others to run the country, if the voters believe the elected are mishandling the job which can include running wild deficits they vote them out. So your statement seems to apply in text books, not the real world.

        By linking bank balance sheets to reserves is simply wrong. Banks are limited by capital and to a lesser degree liquidity, not reserves. A large number of western countries requires no “reserves” at all. This is a macro prudential tool that plays very little role in modern banking. Suggest you update your 1970s text book on this one.

        Yes there are structural differences but financial repression in the US has reduced the deficit, and the reduced financial repression in China (lower growth using the Pettis definition of repression) has resulted in lower surplus. So whilst the drivers are different the results have been the same.

        Negative real rates drive up saving – don’t understand the logic here at all.

        • “By linking bank balance sheets to reserves is simply wrong. Banks are limited by capital and to a lesser degree liquidity, not reserves. A large number of western countries requires no “reserves” at all. This is a macro prudential tool that plays very little role in modern banking. Suggest you update your 1970s text book on this one.”

          I’m well aware that banks are capital constrained. However, changing the amount of reserves is exactly how central banks change the rate of interest and contracting the amount of reserves by enough of an amount will eventually force banks to contract their balance sheet. If the Fed decided tomorrow to raise reserve requirements by 300% (raising reserve requirements by 167% would cause the excess reserves in the US banking system to go to 0), all of the excess reserves in the banking system would disappear and short term interest rates would shoot up and banks would be forced to contract their balance sheet. You can also increase short term rates by reducing the amount of reserves in the banking system by having the Fed simply swap retire the reserves and sell the long end debt. Believe me, I’m not using a 70s textbook to describe the banking system.

          QE primarily works via the portfolio rebalancing effect (which you clearly seem to understand). The Fed is constraining the amount of bonds that the private sector can hold so investors hold more foreign assets and equities while holding less bonds. As the Fed begins to taper/tighten, this process should reverse.

          As for negative real interest rates, they transfer real resources from net savers to net borrowers. Households are net savers while businesses and governments are net borrowers. Households also consume a much larger share of their income than businesses and governments and remember that national savings is simply output minus consumption (S=Y-C). So negative real interest rates transfer income away from households who consume a much large share of their income to businesses and governments, who don’t consume much at all. Therefore, negative real interest rates push up the savings rate. This is a concept that Prof. Pettis talks about all the time and the reason China has such a high savings rate is because the household income share of GDP is so small and thus consumption is small.

  25. Hi Prof.,

    The article clearly explains the lack of the Consumer Inflation but I am not able to understand the absence of the wage increase. Wages should increase on the back of higher demand from manufacturing and construction industries which should increase the domestic. I know that wages are increasing now and many of the lower value adding industries are shifting out of China to other Asian countries, but is higher migration and availability of ample workforce was the reason for muted increase in wages so far or some other policy contributed to it?

  26. MP, This is a great article, but there are 2 things i don’t get.
    1 – how do you justify your claim that wage inflation in China is low, given that so many other articles point to rampant wage inflation.
    2 – you refer to the increase in global commodity prices as being an exogenous driver of inflation in China, while many commentators attribute these same increases to growing Chinese demand. How did you come to this conclusion?

    • Simple. #2. High Chinese demand causes prices to go up. Rising commodity prices cause higher input costs that cause higher prices, thus inflation. Both MP and the others are correct but MP assumed you understood economics 101.

      • My point is that it’s not exogenous if it’s caused by the increased demand in China. So the increased money supply has led to increased inflation, contrary to MP’s assertion that it has not.
        “One of the apparent puzzles about China’s growth trajectory, especially in the past decade, is the seeming disconnect between rapid monetary growth and relatively stable domestic inflation”

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