‘China’s economy is dangerously addicted to cheap money’

(This interview, with Prof Patrick Chovanec, who teaches at Tsinghua University’s School of Economics and Management, was published in DNA edition dated November 8, 2010.)

Patrick Chovanec straddles several worlds with equal felicity. In 1994, as an aide to the then US House Minority Leader John Boehner, he got an up-close, hands-on experience of the workings of the US political economy at a time of budgetary crisis. Last week, when his former ‘boss’ Boehner led the Republican Party to a majority in the House of Representatives (of which Boehner will become Speaker), Chovanec watched the proceedings from faraway Beijing, where he now teaches at Tsinghua University’s School of Economics and Management. Along the way, he’s worked for several private equity funds focussed on China and as director of Institutional Investor’s Asia Pacific Institute.

Fusing academic rigour with marketplace wisdom, the much-travelled Chovanec – he has been to over 45 countries and, somewhat uniquely, to all 31 provinces in China – is frequently sought out by the international media for his perspectives on Chinese business, economics and politics. In the wake of last week’s dramatic US Congressional elections (in the run-up to which trade and political tensions with China were a hot-button issue) and the announcement of a second round of Quantitative Easing in the US, DNA Money’s Venky Vembu spoke to Chovanec for his thoughts on the implications of these developments for China and the region, and other underlying risks to the Chinese economy. Excerpts:

What will the second round of Quantitative Easing in the US (QE 2) achieve? Is it a case of throwing good money after bad?

This is an experiment based on a theory that (Fed Chairman) Ben Bernanke developed when he was a scholar of the Great Depression: his conclusion was that the Fed had not been aggressive enough in injecting liquidity into the economy to fight deflation. He vowed that if he became Fed Chairman he would take “extraordinary measures”. That’s in the realm of theory. The critical aspect is that if he overshoots or gets his timing wrong, he will – instead of fighting deflation – end up creating inflation. That’s one challenge.  

The other danger is of asset bubbles. The policy is intended to lower interest rates on Treasuries and direct investments elsewhere. If those are productive investments, they’ll achieve the goal. But the danger is that it creates asset bubbles. Alan Greenspan was criticised for doing precisely that after the dot-com bubble crash; by being too aggressive in reflating, he helped create the housing bubble. Instead of correcting the underlying problems in the economy, the money just went from one bubble to another.

When there is a credit meltdown in the economy, one of the immediate problems it faces is of liquidity; everybody hoards money. Injecting more money into the economy might address the liquidity crunch. But if there are other issues that need to be addressed – like excess debt or finding new sources of competitiveness – it won’t do that.

As we move into recovery, maybe some of the scepticism is that the problem isn’t necessarily of liquidity but deeper than that, and injecting more liquidity just creates inflation without addressing the underlying problems.

So are there risks on both sides of QE 2: that it could underperform or overshoot?

If the diagnosis is right, the theory is sound, and this is the right prescription. But it’s not clear that that’s all that’s wrong – or even primarily what’s wrong – with the patient. And even if it’s the right kind of medicine, there’s a danger of overdosing.

It’s not just about risks to the US economy. QE 2 creates complications around the world, which other countries aren’t too happy about. The most direct and obvious – and the most immediate – is that the bubbles it creates won’t be just in the US. Money taken out of Treasuries might go into emerging markets, and in that case, you have hot money fuelling growth or potentially feeding bubbles in other countries. And if the Fed decides at some point later to raise interest rates, you cut the legs out from under the flow of capital into that other country.

We’re getting to a point where the US dollar may – because of QE 2 – become the focus of a ‘carry trade’. It won’t necessarily help the US recovery, and it will fuel very fragile growth abroad. I say ‘fragile’ because it could be a bubble – and even if it isn’t, it’s vulnerable to monetary shock from the US. US monetary policy doesn’t just affect the US; it affects the rest of the world and that’s why developing countries, in particular, are concerned.

India, China and other developing countries are at a stage where they are more concerned about inflation than deflation. China effectively had a huge QE over the past year: it had a big monetary expansion, and is trying to deal with the consequences of that and rein in inflation by raising its rates and tightening. That creates incentives for money to flow from the US to China. It’s also true of India and any other country that’s raising interest rates.

There’s of course a very easy answer to this: allow your exchange rate to adjust, and allow your currency to appreciate. If you keep the exchange rate fixed, you’re going to import inflation from the US. That’s the real bind: you either import inflation from the US or you appreciate your currency and make your export orders less competitive. It’s not just China; a lot of developing countries don’t like being put in that bind by the Fed. That’s why they are upset.

What options did US policymakers have? For more than a year, they’ve been trying to persuade China to appreciate its currency, but if anything it’s depreciated it further.  And a stimulus in the US ends up creating jobs in China.


There are all kinds of reasons why China should be moving off the currency peg – and not just because the US is upset about it. The importation of inflation is high among them – and it predates QE 2. Instead of allowing its exchange rate to adjust, every time the People’s Bank of China accumulates reserves by buying dollars and issuing renminbi, it fuels inflation in China. It puts China in a situation where it has to run a constantly tightening monetary policy just to stay in place and prevent inflation, because there’s a huge inflationary pressure from maintaining the peg. QE 2 is going to intensify it potentially, and it’s going to complicate China’s efforts to combat inflation in other ways.

QE 2 does one other thing: the dollar is likely to depreciate in value as a result of QE 2, even though that’s not the intent of the policy. And because the renminbi is effectively pegged to the dollar, it will also depreciate relative to other currencies. If you’re Indonesia, Vietnam or the Philippines or any other country competing with China for exports, China’s goods are becoming cheaper relative to yours – unless you drive down the value of your currency. That’s creating problems for countries that compete with China.

Does this accentuate the ‘currency war’?

It’s pushed it front and centre. There is clearly a divide in the G20 between the US, which was pushing for a stimulus across the G20, and eurozone and the UK, which have embraced austerity – at least on a policy level – and have resisted US calls for another stimulus. Then you have countries like India, China and other emerging markets, which are worried about inflation and overheating. Everybody is on a different track, with different sets of concerns. There was always a tension in the G20 meetings over the past few years, but because nobody had taken a radical step in any one direction, they all agreed to disagree.


QE 2 changes that: you’ve taken a world reserve currency and you’re doing something dramatic with it. Now, everyone else has to respond to that in their own monetary policy, in ways they probably don’t want to respond. They are not in the driver’s seat anymore, which is why we may see some real disagreement in the G20 – either in the open or behind closed doors. And for once, it’s not going to focus on the renminbi, but on the dollar.

What are the risks that it might trigger an all-out war?

The danger is that it could evolve into that, in the way it did in the 1930s. Everybody knows that’s a lose-lose proposition. But people don’t like being put in a difficult spot in terms of their own monetary policy. It’s like a Prisoner’s Dilemma. Individually, they’re all better off if they fight, but collectively they’re all worse off.

Ahead of the G20 meeting, is China off the hook and is the debate over renminbi appreciation on hold for now?

It’s not over at all; the renminbi is the other part of the equation. One of the complications is the effect that the dollar depreciation has on the renminbi, but that’s only because China chooses to maintain the peg. If China moves off the peg, that would remove a big part of the problem.

Since it’s the US and China that appear to be principally muddying the waters, does a resolution need ultimately a bilateral currency agreement between them?

The currency debate is very often discussed as though it’s purely a bilateral issue between the US and China, but it’s not – both in terms of the effect of appreciating and depreciating currencies, and in terms of the impact on trade and investment flows. If the RMB were to appreciate, the correction wouldn’t just take place between the US and China. It would involve a lot of other people as well. It’s not as if the US will suddenly start making textiles if the renminbi becomes less competitive; trade could simply shift to third countries. Maybe Americans will move from buying more expensive Chinese goods to buying cheaper Vietnamese or Philippines or Indonesian goods. That’s obviously a positive effect for those third countries. But whether it’s the flow of investments or trade, this involves third countries, and that’s often forgotten.

You hold the view that inflation is a much bigger problem in China than most realise: what do you see that others don’t?

Over the past year, China had a huge monetary stimulus: money supply expanded by over 50 per cent over the past two years, and is continuing to expand at around 20 per cent. Wherever you have that kind of monetary expansion, you have to start looking for inflation. So far, there hasn’t been that much by way of consumer inflation in China – according to official figures. It’s been just above 3 per cent. That has a lot of economists scratching their heads: the underlying numbers say there should be inflation in China.

On the ground, when you talk to people in China, there’s a feeling that things are becoming more expensive. When Chinese officials released the inflation figures for September at an official press conference, even Chinese reporters from state-owned newspapers were challenging the officials!

If you follow the money and look at the way it was created in the Chinese economy, the expansion of 50 per cent-plus money supply took place by way of lending, which primarily fuelled a boom in fixed-asset investments. You’d expect to see the first impact of inflation in the place where money entered the economy. You do have asset price inflation in China, with people bidding up the price of land to astronomical levels. There’s massive capacity expansion.

But inflation has to work its way through the economy: it will affect people differently at different times. That creates tensions. You already see wage inflation in China; part of that is due to a tight labour market in China, but part of it is also because it’s very expensive to live in an urban environment in China because the price of real estate is skyrocketing.

The official CPI was 3.6% in September. But if you break that down, food was up 8%; vegetables were up 18%; and in my own experience, the price of my meal at KFC went up from RMB 20.5 to RMB 28.5, which is a substantial increase. But curiously, Yum! Brands, which owns KFC and Pizza Hut in China, said it was actually experiencing a profit crunch in China because the price of labour and the food inputs were going up so dramatically; so even though they raised prices by quite a bit, they’re facing a margin crunch. That suggests that the asset price inflation is starting to work its way through the economy.

I don’t know whether the official figures are capturing it or not; you have to ask whether the allocations are right. In the US, for instance, housing has a 40% weightage in the CPI; in China, it’s about 15% of CPI. For some people, food costs account for much more than is reflected in the official allocation to CPI. You also have to draw a distinction between urban and rural areas; it’s quite possible that in out of the way places in China, you don’t see the same dramatic price changes you see in Beijing, Shanghai and other urban areas. But China is not a cheap place to live in anymore in the way it used to be.

What will it do to the Made-in-China story? Will factories move out or move inland?


The move inland is more of a reflection of real costs of doing business in different places than of inflation. But the worry about inflation is that going forward you have an economy that has achieved phenomenal growth rates mainly because of the injection of a massive amount of new money. There’s 50 per cent more money sloshing around in China than there was two years ago: no wonder people are spending money!

There’s a lot of money floating around, and it’s accounted for a lot of the growth. But you’ve got an economy that in many ways is dangerously addicted to cheap money and easy credit. When I go on TV in China to talk about the latest loan figures or inflation figures, they’ve been asking me, over the last few months: ‘When will we see loosening again?’ Last year, money supply expanded by 30 per cent; this year, it’s just below 20 per cent. That’s tight relative to last year, but it’s still pretty loose.

If your money supply is expanding at 20 per cent and people are complaining that the monetary policy is too tight, and they can’t survive, it’s a warning sign that people are becoming too dependent on easy money to fuel growth. And the danger is that if inflation does get out of hand, and you see asset price inflation surge into consumer inflation in China, they’re going to have to respond by cutting off the flow of liquidity into the system; that’s a recipe for a hard landing.

You teach Chinese students about American Business History and Doing Business in America, and have served in the US government. What will the deadlock in Congress – with Republicans in charge of the House and Democrats controlling the Senate – do to policymaking in the US? Will a Republican-controlled House end or accentuate ‘China-bashing’ of the sorts we saw in the run-up to the elections?


Not all articulations of concerns about China amount to ‘China-bashing’: some of them are legitimate concerns about the economy and US’ relationship with China.  Congress and the administration have become concerned about these, particularly over the past couple of years. You did see what I think people would consider ‘China-bashing’ during the recent elections; perhaps some of the intensity of that will diminish. But I don’t think the underlying issues have gone away. This isn’t a Republican-vs-Democrat thing; you have growing concerns in both parties, but with different focus or emphasis. Democrats tend to be more concerned about the economic threat from China to American jobs. And that has been manifest in some of President Obama’s trade tariff actions; a lot of those tariffs have originated in petitions submitted not by US industry groups but from labour unions, which are the main constituent groups of Democrats. They’ve been upset about China for quite some time and want the US to take much more aggressive action. Republicans tend to be concerned about national security issues.

In both areas there are legitimate concerns, and they’re growing. There are differences of opinion on China, and a range of opinions, in Congress and in the administration, but they don’t break down neatly on party lines. You can see the range of opinions in either party – from people who are for engagement with China to people who are China hawks. That will be reflected in the debate going forward.  But because there is an even distribution of power right now, and because both sides are going to be positioning themselves for the 2012 presidential elections and framing issues that they think they can beat the other guy up on, it will prove to be a big temptation – just as it was during the last campaign – to use China as a bludgeon. You will see more of that rhetoric.

If you want to get an idea of the political opinion in the US about China right now, it’s instructive to look back at attitudes towards Japan in the 1980s. There were very similar concerns about the rise of a new economic superpower and what it meant for Americans. Today, those concerns look overblown. But China is filling those shoes. If you had a hard landing in China – if inflation builds up and they have to pull the plug on growth – we could be talking about a very different story about China in two or three years than we’re doing now. For now, however, there are these concerns about China.

You said recently that China needs a Southern Tour – of the sorts that Deng Xiaoping undertook in 1992. In what context did you say it, and what will it do?

One of the things you’ve had happen in the past year or so in China is a resurgence of the state-owned sector. The catch-phrase 国进民退 (guo jin, min tui: the state advances, the private sector retreats), which although not an official motto, is invoked by entrepreneurs who feel marginalised. There are a couple of different reasons why this has happened. One of them is that the lending boom that took place last year tended to favour state-owned entrerprises (SOEs) and give them access to a lot of resources. It wasm’t intentional: it was just a reflection of the fact that the state-owned banking system tended to be most comfortable lending to SOEs; they tended to have more collateral and seemed less risky. Private entrepreneurs found it difficult to tap into that.

Second, during times of economic distress, there’s a natural tendency to feel protective; in China, there is this appeal of the national champion model, where if you’re an SOE (or a private company with lots of state sponsorship), you are priming to be a leader, and you don’t want too many challengers. In this environment, they lent all the more support to their ‘national champions’; that was a natural defensive response to economic turmoil.

The third thing that happened was that around the world where there was growing scepticism about the markets, a greater emphasis on government intervention in the economy. Lay that over China, where you have a Communist Party and the state has a big role in directing and managing economic growth. There were a lot of bureaucrats in China who said, ‘We have a model that’s so much better.’ Even senior Chinese officials and leaders said, ‘Our system gives us a lot of other mechanisms that other countries don’t have.’ That also shifted the emphasis to the state. I think this is all very short-sighted. You can insulate yourself from shocks, but an insulted economy is not a dynamic economy. An economy that’s dominated by bureaucracy, by monopolies and semi-monopolies and protected markets… can be insulated from shocks, and so may not see the market turmoil you see in more open economies; but that’s not going to be a dynamic economy going forward.

Take the banking system: a lot of people in China feel ‘we’re so much better off with a state-owned banking system which is insulated from shocks’. The danger in a US-style system is that you get these very dramatic corrections that create a lot of turmoil; they’re severe, and they may have collateral damage and a lot of pain. But the good thing about that is that at least you have a correction. People no longer tend to misallocate resources, building homes that nobody can afford . The danger in a Chinese system is that it’s so insulated you never get a correction. You don’t have the turmoil or the shocks, but you keep on misallocating resources. Over the long haul, wasting resources and putting money where it doesn’t belong and building buildings where nobody is going to live in or building highways that nobody is going to drive on. This is actually a much greater concern than the painful shocks that are experienced in a more open economy.

Nobody likes having a recession, but the only thing worse than having a recession is never having a recession. That means the dead wood is never cleared out; and there are no punishments for doing things wrong.

Other analysts have persuasively argued that China isn’t building bridges to nowhere, and that China’s infrastructure is actually lagging behind its need for its stage of development. Do you not agree?


It’s difficult to paint it with a broad brush on that. I hear different things from different people. My view is that it’s a mixed bag: there are investments that China is making that are going to pay off big, but there are other investments that are more about throwing money at the economy than about getting a return. I am concerned that there is enough of this fixation on generating GDP through fixed-asset investment. In China, the financial system isn’t really attuned to a return on investment, so you don’t get the correction you need to keep the economy on a sustainable track.

Related reading
‘This is a very dangerous time for China’:
Interview with Dr Jim Walker
‘China’s biggest risk is that it doesn’t change its economic model’:
Interview with economist Stephen Roach
‘Much of China’s GDP vanishes into thin air’:
Interview with David Scissors
Why China needs to change:
Interview with Arthur Kroeber
Bigger the boom, bigger the bust: China is no exception to that rule‘:
Interview with Richard Duncan
‘China’s nuclear bomb is a dud’:
Interview with Michael Pettis



About Venky

Journalist, blogger, amused observer of worldly goings-on... More about me here.
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5 Responses to ‘China’s economy is dangerously addicted to cheap money’

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