China's Money Supply, Inflation and Currency - Some Observations

* China’s money supply, inflation rates and their currency – I want to circle back to the piece I wrote on Monday. The most notable observation from Monday’s piece was the startling amount of money in China’s economy. The Chinese Money supply (M2) is over two times its GDP, while in the US, the Money Supply (M2) is about 2/3rd the GDP. Does this represent latent inflation, or just a quirk about the Chinese. I have two theories on why the Chinese Money Supply is 3 times the US’s money supply, relative to its economy. The first is that with a population of 1.3 billion, each individual might have some nominal demand for holding currency, or small time deposits, while the US’s population is 25% ofChina, and with a lower population, has a smaller demand for holding currency. The other theory I have has to do with the fact that the US has a more evolved banking system than China, with greater trust in the domestic financial system. The implication of this idea is that the Chinese might hold more money in the form of cash, rather than in banks, which would decrease the velocity of money by a large measure. 


Either theory could explain why a given amount of money is needed to support a certain amount of economic activity. Clearly the utilization of money in the US, is three times greater than it is in China. If the two reasons I just mentioned explain why China has a lower money utilization rate than the US, then one could surmise that the high levels of China’s money supply would not be inflationary; Just like the US in second half of 2008, when the demand to hold cash dramatically increased, and the Fed printed over a trillion of quick cash, with no impact on inflation, at least not yet. The data shows that the 10 year inflation rate in China is 1.9%, while over the same period, the Chinese money supply has grown at an annual rate of 17%. Clearly the traditional concepts of the velocity of money, and its role which an increase in the money supply has on inflation does not seem to apply here. Looking at other measures of inflation, real estate prices have risen at an annualized rate of 4.7% over the last 10 years, which is higher than the CPI increase, but well below the growth in the Money supply. China’s economy is largely controlled by state run enterprises, with the ability to fix many prices, so most of this information has to be suspect due to the control the government has over prices, and not a true measure of inflation of a market based economy.


A reader writes in with a comment about my observation that China’s growth in its foreign currency reserves has been $600 billion greater than its trade surplus:


“On China’s $900B of trade surplus versus $1.5T (increase) of FX reserves, the $600B difference is evidence of a devaluation mechanism for the Yuan. If China did not sell $600B of additional Yuan over the period the Yuan would have strengthened further versus the peg (the fixed exchange rate which the government sells Yuan).


What comes first, the trade surplus or the FX reserve? Often we hear in the media that China’s trade surplus results in a large FX reserve. But it could really be the other way around -  Theoretically, if a nation wanted to gain advantage in the  Terms of Trade it could sell its currency versus trading partners establishing a quasi-subsidy to exporters. The intial sale of the currency would establish an FX reserve and a trade surplus would follow. Anyone investing in China needs to think critically about how much of China’s export strength in from true Comparative Advantage versus temporary currency related subsidies. What’s more, how much of China’s domestic growth is related to supporting export industries that may or may not be economically profitable without subsidy.” (end of reader’s comment)


The reader raises a few interesting points. The first one has to do with the fact that China is actively printing currency which it has likely sold to increase its foreign currency reserves. This in turn could be used to help maintain some equilibrium relative to the fixed exchange rate it sets. I would further extend the discussion to suggest that even if China allows its currency to float, which the headline on the front of today’s FT indicates, then China might be able to sell enough of its currency to keep it from appreciating significantly. So even if China agrees to float the currency, or allow it to appreciate, there are other things which they can do which would suppress it’s value against other currencies. In turn, this could be equally manipulative.


And how would it sound if we accused China of manipulating its currency by virtue of printing money? Isn’t this what the Fed has done over the last year? Is the US a currency manipulator on the same basis?


* Housing redux – in response to my piece yesterday about the government’s plan to encourage principal forgiveness for upside-down mortgages, a reader writes in with this comment:


“(Do) you realize there are well over 7 million homeowners out there who are not currently paying their mortgage, and that number is increasing by approximately 250,000 per month. As it stands, with homes not liquidating, we have well over a year of down to flat home prices anyway.  If you let that many units foreclose (and who knows what the liquidation time-line is if that happens), it would be armageddon. The cycle of new defaults because of negative equity would be vicious. Having said that, I agree with a lot of the points: moral hazard and inequality for people who most likely defrauded the system in the first place is a very difficult thing for someone playing by the rules and  having taxes jacked in their face, to accept.”


And lastly, another reader shares these sentiments:


“I made some bad investments over the last few years as well – I would like my money back too.  This plan makes me sick!”


Tea Party anyone?