By Jason Hsu
The U.S. Fed’s recent rounds of quantitative easing are often understood as a vehicle of the Full Employment Act – and rightfully so. It works like this: the Fed expands its balance sheet by borrowing digital currency from the universe, as if posting IOUs to God; the Fed then lends that money to the U.S. government in exchange for Treasury bonds; and the government spends that money to stimulate U.S. employment and growth. With each new round of easing, the U.S. government’s debt grows in tandem with the Fed’s balance sheet.
The beauty of this system is that the U.S. government can never default, because it can always borrow more money from the Fed (who borrows from our infinitely patient Maker) to repay its debts to the Fed. One has to admire the elegant circularity of this approach. It is among the privileges of maintaining sovereignty over one’s currency, a privilege the Greeks relinquished to their regret.
The U.S. Fed is not the only central bank to engage in quantitative easing. To the consternation of some economists, developed countries across the globe use the practice aggressively to promote regional employment and growth. By contrast, casual central bank watchers have noted China’s relative restraint. Compared to the central banks in many developed countries, the People’s Bank of China’s (PBC) balance sheet looks fit and healthy, and Beijing’s finances are as strong as ever.
What troubles China-watchers is the mounting debt owed by local municipalities and Chinese state-owned enterprises (SOEs). The state-owned banks who lend to these institutions are also increasingly laden with bad loans. This situation is arguably dire. Municipalities and SOEs could default, toppling banks in a domino effect that yields a financial market contagion. This is precisely the kind of financial crisis the U.S. experienced during the recent sub-prime debt crisis. At least, so argue the China bears.
I believe the argument described above fails to recognize the Chinese approach to quantitative easing. First, we can view Chinese SOEs as extensions of the Chinese government. Staunch advocates of laissez-faire, who are often critical of SOEs, should note these SOEs are at least as efficient as any state bureaucracies– Chinese, American, or otherwise. Second, we can view state-owned banks as extensions of the People’s Bank of China (PBC). It is clear that these banks do not lend to municipalities and SOEs based on careful credit analysis designed to maximize profit; instead, they lend because these massive entities are major employers that are crucial to stabilize the political economy. Needless to say, Beijing and the PBC will back state-owned banks with unlimited funds (IOUs to Buddha?) so they can continue financing municipalities and SOEs to maintain and create jobs.
As you can see, there is a striking parallel between China’s quantitative easing and that of Japan, U.S. and Europe. Just as the Fed expands its balance sheet to bankroll the U.S. government, so does the Chinese central bank – through its state-owned banking satellites – expand its balance sheet to lend to Chinese government subsidiaries to promote employment and growth.
I am not the first to observe this parallel. But I’m going to make an uncharacteristic forecast based on my observation. (Those who know me well, know that I rarely make forecasts. I’m acutely aware that writing a blog does not give me an edge over other talking heads in the often misguided attempt to forecast the macroeconomy, so consider yourself warned). My forecast is this: I believe the predictions of municipal and SOE defaults are grossly exaggerated, if not outright misdiagnosed. So beware the China bears. And consider this: once we recognize Chinese quantitative easing for what it is, it’s not difficult to imagine a similar parallel between the path of future RMB and global currency interest rates.