American and Chinese Monetary Policy : a Macro Perspective

A (short) but interesting piece by UBS Wealth Management Research comparing the monetary stance of the FED and PBOC.

For years, observers have turned to the ECB to provide them a comparison-basis to judge the FED and its policies. As Europe is likely to undergo an extended period of under-par growth and internal questioning and as China gains momentum on the international scene, attention will turn to the Chinese central banking model and how it fares relatively to its Northern American counterpart.

Comparing China and America is a perilous exercise given the stark differences between both countries. A country of 1.3 billion inhabitants which has undergone in the past 30 years the fastest-paced political and economic streamlining in history cannot fall under the broad definition of being a "capitalist" or "communist" country. 

Moral hazard, defined as governmental intervention to bail out insolvent parties, is often referred to when describing the USA. Not China. There is no Xiaochuan put. What the US spent to save AIG, the Chinese government used to build infrastructures. 

In the 1980's, benefiting from the opening up of the local market, western banks started settling in China and making a series of bad loans to local entities. They took for granted the Chinese government would step in and prevent national companies from failing. It didn't.

As embodied by chairman Bernanke's reelection, trying and failing is accepted, if not rewarded, in the US. In China, accountability of governmental institutions is the first pillar of social rest. In China, the Party cannot fail. It has to "cross the river by feeling the stones(1)".


How monetary policy is considered, channeled and judged is highly impacted by these divergent mantras.

• Correlated Quantitative Easing, Mixed Results

Bernanke had announced(2) he would fight deflation at all costs, referring to Milton Friedman's "helicopter drop" of money. The least is to say he held tight to his principles, adding $813 billion to the FED's balance sheet in the 5 months to August 2008.

With hindsight, it seems that decoupling presented to heavy an opportunity cost for China and its government. Lacking internal demand and economic knowhow, China had to make do with the US, and reciprocally. Even today, it is hard to say where the USD would stand if the renminbi peg had not be resumed in mid 2008, triggering in the process a rally in the greenback.

Whether it was targeted at sustaining national economic growth, limiting the downside risk on its trade account, or maintaining the renminbi/USD peg, China correlated its monetary stance to its western counterpart's. Monetary mass expanded y-o-y by 32% in China, leaving the country awash with liquidity.

Chimerica had committed to quantitative easing.

Confidence is the backbone of monetary policy efficiency. Without confidence, monetary expansion boils down to pushing on a string. 

On the one hand, the FED's credibility had been eroded in the wake of the IT bubble with the so called Greenspan Put. On the other hand, People's Bank of China is ran by the Chinese government which, contrarily to the prevalent opinion among China bears, is supported by its people.

In the US, banks witnessed how market speculation had triggered a run on Bear Stearns, and fear grew they were exposed to similar margin call risks. In China, People's Bank of China has a significant stake in local banks and is hence capable of influencing their policy.

This diverse drivers resulted in similar quantitative easing policies being channeled in deeply divergent ways, and thus entailing different outcomes.

• Where did the money go?

As a major share of their assets were valued according to mark-to-market standards, fading confidence resulted in a rapid downsizing of American banks' balance sheets. Relying on risk models based on the erroneous assumption of normally distributed returns, banks were caught off-guard. Being granted almost overnight a "free lunch" by the FED's  easy money, they used the freshly printed dollars to increase their reserves and thus hedge their margin call risk exposure.

The central bank is entitled to supply aggregate reserves. The FED did so by expanding its balance sheet to record levels. However, it is the bank's role to supply end money (currency in circulation). It is their behavior which drives the deposit expansion multiplier. Designating the incremental money in circulation for each dollar added to the monetary base, the money multiplier is correlated to the banks' willingness to lend. 

When the crisis peaked and confidence dropped, the deposit expansion multiplier plummeted.


A situation both visible in M1...:

...and in M2:

As a result, M2 increased by $538 billion when the FED's balance sheet had expanded by $813 billion, a 40% difference. Bernanke succeeded in what he thought central bankers had did wrong during the Great Depression of 1931: printing sufficient money to maintain M2 expansion. History has taught central bankers a major lesson : when confidence plunges, base money supply is a poor indicator of money in circulation and thus of market liquidity.


The banks' reluctance to lend prevented the FED's expansionary monetary policy from kick starting the real economy. However, the excess money was channeled by institutional investors to financial markets and ignited an asset reflation-led recovery.


China offers a brighter picture of monetary policy effectiveness, local banks having lent accordingly to the PBOC's centrally planned and directive policies. 

1 is the money multiplier threshold. Above 1, growth in the money supply exceeds base money growth. Under 1, the outcome is the opposite. Since 2007, M2 growth in China has outpaced GDP growth, implying a money multiplier >1.
Less leveraged and more state-driven than their western counterparts, Chinese banks succeeded in providing the necessary liquidity to both the real and financial domestic markets, hence maintaining annual real GDP growth >5%.

During the 4th quarter of 2008, the PBOC started by pausing its emission of central bank bills in the exchange market (sales that were aimed at offsetting upside tensions on the RMB created by the trade and capital account surpluses). 


It is also worth noting that the financial environment was different before the financial crisis in China and the US, thus resulting in divergent monetary policy outcomes.
China had taken advantage of its above par expansion pace to streamline its banking system through massive capital injections and non-performing loans write-offs. The dramatic increase in liquidity in the inter-bank money market has thus spurred a rapid increase in bank credit and broad money supply.


Part 2: Money Never Sleeps, Inflation outlook in the US and China

(1) “Crossing the River by Feeling Each Stone” refers to the pragmatic policy of Deng Xiaoping, to move ahead with economic reforms slowly and pragmatically.

(2)http://www.federalreserve.gov/boardDocs/speeches/2002/20021121/default.htm

American and Chinese Monetary Policy

Moral Hazard and the Corporate fixed income market

As shown by this chart (courtesy of Zero Hedge), European sovereign spreads measured by the Markit iTraxx SovX Western Europe Index have risen higher than corporate iTraxx indexes for the first time in history, reflecting growing fears of a sovereign default tail risk in 2010.

First, the analysis requires mentioning that the geographical composition of both indexes differs.

As described by Markit, the SovX indexes include:

• Markit iTraxx SovX G7 – tracking the credit risk of the most industrialised countries in the world.
• Markit iTraxx SovX Global Liquid IG – tracking the credit risk of countries in Asia Pacific, Eastern Europe, Latin America, Middle East & Africa, North America and Western Europe.
• Markit iTraxx SovX Western Europe – tracking the credit risk of 15 countries in Western Europe.
• Markit iTraxx SovX CEEMEA – tracking the credit risk of 15 countries in the CEEMEA region.

If the breakdown of the corporate index is not disclosed, the inversion of the curve would not be witnessed were both indices to be trade-weighted in the same way.

Second, the limited lifespan of the European SovX index must be discounted, the index having been opened to trading only since September 2008.

However, the spread between the Sovx and Corporate indexes stands at a record-low level and even turns negative without the geographical distinction.
On the one hand, debt-laden governments face increasing doubts from investors regarding their ability to fund both previous and upcoming fiscal stimuli. We distinguish two premia drivers depending on country monetary independence:

• Fiat currency countries: Being able to use quantitative easing strategies to inflate out of their debt, there is low tail risk these countries will default. In these countries, spreads are driven primarily by inflation expectations.  
• Countries with no/low monetary indepence: as it is the case for Greece, increasing CDS spread are driven by default risk perceptions. 

On the other hand, corporate spreads are driven lower by develeraging and a global improvement in corporate cash flow generation. There is little doubt investors also consider central bank interventions will be led were corporate default risk to appear. The sheer definition of moral hazard.


As a result of these trends, credit default swaps spreads between European sovereigns (equally weighted) and the European investment grade credit universe have significantly tightened.

This news comes as corporate bonds issuance and subscriptions reach record levels, suggesting that Q1 2010 could provide credit markets with a 2009-type windfall.
On the sovereign side, the yield curve between 10y and 2y has reached the 288 basis point record mark, reflecting growing anticipation the FED will hike rates sooner than expected.


Were central banks to move towards interest rate raising, the trend on corporate bonds yield will reverse as bond price go down. As seen on the chart, the corporate itraxx has retraced its Lehman related increase and has been range bound during the last 2 months.


As the spread between government bonds and high investment grade corporate bonds closes to 0, investors will increasingly shift to riskier positions.

The Currency Issue

A new year, and most importantly a new decade. Investors place great hope in 2010 as a turning point, as if the year could provide them with a new starting point.

As the subprime scheme unraveled and triggered a global credit crisis, hopes placed in the 21st century as the new moderation era have vanished. Whether it stems from IT-driven business models, ever increasing house prices or global decoupling mythes; one lesson we shall keep in mind is that mean reversion is the norm and genuine paradigm shift the exception.


Throughout the unraveling of the housing and credit bubbles, governments have globally put to extensive work their currency printing press. For this reason, at least, currencies are bound to play a center role in the development of the global economy.


Hence, as a reminder to myself more than as a attempt to forecasts random macro upheavals that could occur in this new year, I here list some key developments we could witness. None of them are time bound, and all of them are imagination driven.

• As directional risk in global portfolios increased due to growing asset correlation, currencies' role as an independent asset class will rise. In the era of uncertainty, investors seeking liquidity and transparency will certainly allocate a growing share of their portfolio to currencies. Currency-based portfolio diversification should gain further momentum due to the increasing attention given to ETF vehicles.

Active currency in portfolios is used in two primary ways. Either via an active overlay to a plan's international exposures or by taking on currency as a separate or alternative asset class … However for all intents and purposes, active currency has zero correlation to the major equity and fixed income asset classes. … In the search to add non-correlated series to achieve diversified returns, active currency can play a significant role. KATHY MANN, Currency as an asset class

• As sovereign-credit fear rises in 2010, the prices of the dollar and the euro will be increasingly driven by country risk exposure. Were fears to grow on one of the country's economic partners, the dollar will likely overshoot to the downside. 
• In this scenario, Greece and Ukraine could  represent a significant downside tail risk for the euro, and trigger a rally in the dollar. This could further delay the awaited renminbi depeg.

• As the mix between short-term and long-term unemployment becomes increasingly skewed towards the latter in developed countries, social resentment will feed a new wave of political backfire against currency manipulation. Due to the its comparatively low labor cost base and its growing role in the global economy, pressure will likely mount on China to revalue. 
• China is certainly to keep its peg until the 27% increase in the dollar value that occurred between July 2008 (when the Renminbi peg was reimplemented) and November 2008 is fully retraced.
• There is little doubt the Chinese moderation principle will once again be applied to the renminbi revaluation. Fragility in the banking sector, doubts on probable government-led price distortion and record monetary expansion (+32% year on year) are too significant bulwarks to a free floating yuan to be ignored.

• Recent political developments in Japan and associated moves in the yen relatively to other major currencies suggest political announcements will be a major driver for the currency. Two lost economic decades and the country's remote location from the economic Asia-Pacific zone are major impediments to a short-term growth resumption. 

• National policies in Japan will focus more importantly on internal macro tweaking. As a result, and until a renminbi detachment provides investors with a third major currency position, the correlation between the euro and the dollar should further its way to -1.
• As it hovers around 1.5, the euro/dollar (EURUSD=X) still stands 7% short of its July 2008 level when the Renmibi peg was made reeffective. Hence, a Chinese revaluation in the short-term could send the euro above the 1.60 mark against the euro. 

• Governments relying on highly price elastic goods and services or/and willing to inflate their way out of debt could engage a 21st-century "beg my neighbor" global policy.

• As governments pursue their asset reflation policies, greater currency debasement is expectable. In the short-term, chances are these policies will be equivalent to "pulling on a string" as long as credit creation remains in negative territory. Were lending and confidence, its compulsory counterpart, to resume, higher inflation will feed in the real economy thus increasing the macro-risks pending.

As noted in JP Morgan's 2010 EMEA Outlook:

Currency markets do not meet the usual criteria for bubbles –extreme valuation, momentum and leverage.

In the risk averse environment we trade in, this could prove to be the most important driver to the FX market.