Chapter 2 The Effectiveness and Sustainability of the Sterilization Policy in China 5
2.6 Summary
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2.6 Summary
To stabilize the exchange rate of the RMB and further realize sustainable development of China’s economy in the context of persistent balance of payments surplus and the intensified upward pressure on the RMB, the PBC uses a variety of sterilization measures and foreign exchange market interventions to reduce excess liquidity and maintain the stability of RMB exchange rate and the monetary policy independence.
Based on microeconomic foundations and with the perspective of minimizing the target loss function of monetary authorities, this study aims to construct a refined model for offset and sterilization coefficient estimation to evaluate the effectiveness of China’s sterilization policy. Besides, empirical data are used to further explore financial capabilities of the central bank in order to understand the sustainability of the sterilization policy. The empirical results show that Chinese monetary authorities sterilize almost all effects of international capital inflows and increase in foreign exchange reserves on the monetary base. That is, increase in capital liquidity does not sabotage the independence of the Chinese monetary policy. Nevertheless, analyses of sustainability of the sterilization policy indicate that the sustainability of the monetary sterilization policy has been seriously challenged since March 2008.
In the context of rising costs of sterilization, massive and persistent international capital inflows have made it difficult for the PBC to achieve its twin goals of currency stability and monetary policy independence. In light of these circumstances, the monetary authority should not only adjust the maturity structure of the central bank bills to ease the pressure for making interest payments, but also actively develop diversified sterilization tools to compensate for the inadequate effects of sterilization measures. Moreover, the monetary authority should relax restrictions on capital outflows and adjust the imbalance in the balance of payments. Furthermore, this should help improve the exchange rate system and mechanism for adjusting the exchange rate to adjust the external imbalance of the economy, expand the ratio of foreign reserves held by enterprises and for gradually abolishing the provision on
“allowable foreign exchange working position” for designated banks. These measures can alleviate pressure on the PBC for its passive role in the foreign exchange market interventions.
The persistent balance of payments surplus has eroded the autonomy of the central bank. As a result the Chinese government should focus on policy coordination.
In addition to increasing the issuance of government bonds and raising the proportion of government bonds within the monetary authority’s assets, coupled with effective
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exchange rate management to control for speculative foreign investment, the government has to adjust the corresponding macroeconomic policy in order to effectively address the economic and asset bubbles due to excess liquidity.
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Chapter 3
Short-term International Capital Inflows and Asset Markets in China
3.1 Introduction
In the context of globalization and internationalization, short-term international capital constantly flows across borders in search of arbitrage opportunities in the flourishing international capital market. Governments have gradually started paying attention to the resulting effects and impacts on their capital markets. In response to RMB appreciation expectations, the wide interest rate spreads and a generally optimistic outlook of China’s economy, a considerable short-term international capital has flown into China in recent years, largely in the hope of making arbitrage profits in the domestic capital market.1 In 2011, foreign investment in real estate development enterprises stood at 78.52 billion RMB, up by 96.21 percent over that in 2006. Direct investment in the property market by foreign investors was 38.65 billion RMB, up 127.53 percent over that in 2006.2
The People’s Bank of China has continuously followed a sterilization policy along with foreign exchange market intervention, to stabilize the foreign exchange market. With inadequate sterilization, the increase in funds outstanding for foreign exchange due to the inflows of short-term international capital result in increased domestic money supply, further pushing up property prices. While short-term foreign capital inflows bring about capital mobility, there are already ample funds in the real estate market in China. Consequently, such capital inflows, to a certain extent, result in housing bubbles in some areas.
In addition, by sterilized intervention on a massive scale, the Chinese government has inevitably increased the risks of the financial sector. Since the People’s Bank of China has mandated higher reserve requirement ratios, it not only weakens the autonomy of commercial banks but also lowers the profit margin for banks due to limitations of credit growth. In order to secure their existing market shares, commercial banks are forced to lower their loan standards or turn towards high-risk investments, which may render the loan conditions for specific industries too lax. With an over-abundance of funds and a shortage of other viable channels of investment in China, such circumstances tend to encourage investments and
1 While the capital account in China has not yet been fully opened up, foreign capital can still flow into its capital market through associated channels.
2 See National Bureau of Statistics of China, China Statistics Annual Report.
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speculations in the stock market and real estate market. Consequently, this causes China’s stock market to fluctuate and prices of real estate are being driven up in China.
And as such, despite the various tight monetary policies that the Chinese government has adopted, the scale of mortgage businesses of banks remains steadily on the rise. According to the statistics from the People’s Bank of China, the real estate loan surplus in June 2012 for major financial institutions, rural cooperative financial institutions, urban credit cooperatives and foreign capital banks came to a total of 11.32 trillion RMB (a growth of 10.3% compared to the same period in 2011).
Balance of land development loans, real estate loan balance and individual housing loans came to 803.7 billion RMB, 2.92 trillion RMB and 7.49 trillion RMB, with growth of 0.8%, 11.3% and 11%, respectively, compared to the same period in 2011.
The ratio of China’s real estate development completed investment against the nation’s GDP has grown steadily over the years; by the end of June 2012, the ratio came to 13.48%. These figures reflect the flourishing development of China’s real estate market.3
With this kind of huge investment in the real estate market, housing prices in various Chinese cities have risen considerably; some cities have even experienced a housing market bubble. Given the limited effectiveness of various sterilization tools deployed by the People’s Bank of China, the increase in funds outstanding for foreign exchange due to inadequate sterilization create additional base currency and money supply, thereby amplifying the inflationary pressure for general goods and commodities. Not only that, this also creates a source of funding for real estate that causes inflation. It propels rapid growth in housing prices across major Chinese cities and creates higher risks of housing market bubbles.
Considering the overall current state of the real estate market in China, authorities have implemented an array of policies to suppress rising house prices.
Short-term international capital lurking in the real estate market has started to flow out of the country, leading to collapse in the real estate market. For ensuring the development of real estate market in China does not suffer, understanding the current status of China’s real estate market and the relationship between foreign capital and housing price are the pressing issues.
After introduction, the second section of this paper presents a quick overview of relevant research works and literature, which discuss the relationship between short-term international capital inflow and asset price. The third section provides a concise summary of short-term international capital inflows and asset markets in recent years, and the fourth section focuses on the empirical model. The fifth section
3 See National Bureau of Statistics of China, China Statistics Annual Report.
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covers the data description and empirical results, followed by conclusions of this paper.
3.2 Literature Review
Moderate international capital inflows can boost economic growth of a nation.
Nevertheless, excessive short-term capital inflows impact the country’s asset market, even leading to serious economic crises at times.4 Financial booms and crises in emerging economies are tightly linked to international capital inflows. Large capital flows into emerging markets lead to a financial boom in host countries. On the other hand, when large amounts flow out, the lead to a crisis. Weak macroeconomic fundamentals are one of the major reasons for capital out-flows from emerging markets in the form of hot money. Domowitz et al. (1997) found that hot money from abroad had significantly affected stock price increases and market capitalization in Mexico, and had contributed to the 1994 Mexican financial market turmoil to a great extent. Sarno and Taylor (1999) examined the view that 1997 East Asian crisis was precipitated by bursting of asset price bubbles, which had been fuelled by strong capital inflows that were largely the result of a moral hazard problem in financial intermediation and the situation was exacerbated by a vicious cycle of asset price deflation and incipient and actual capital flight.
Foreign exchange rate is an important channel that connects domestic and international economies and globally experience has shown the close correlation between foreign exchange rates and real estate prices. Given that sterilization policies are unsustainable, public anticipation of currency appreciation triggers inflows of international capital and pushes the prices of stocks and real estate even further up.
Calvo et al. (1996) studied the data spanning 1990 to 1994 of Asian and Latin American countries and the results of their study showed that the inflow of international capital not only causes stock and real estate prices to rise but also result in rapid growth in foreign exchange reserves and money supply, along with appreciation of real exchange rates.
Kim and Singal (2000) estimated changes in the level and volatility of stock returns, inflation and exchange rates around market openings, and found that the movements of speculative funds, particularly in emerging markets, are apparently highly sensitive to differences in interest rates, expectations of currency revaluations and expected returns from holding of securities. Benson et al. (1997) examined the influence of buying and selling by Canadians in a study of 397 residential properties
4 Examples include the burst of the Japanese asset price bubble in the 1990s and the collapse of the housing market in Thailand in 1997.
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in Point Roberts, Washington. They found that the sensitivity of real estate prices to exchange rate changes appears to be a three-to-six month lagged function. In general, it appears that a higher Canadian dollar increases the Canadian demand for Point Roberts real estate which, in turn, leads to higher transaction prices.
Benson et al. (1999) used autoregressive moving average (ARMA) for tracking the data from Bellingham’s housing market for the period between 1984 and 1994.
The analysis suggested that a 10% rise in the exchange rate leads to a 7.7% rise in Bellingham home prices and concluded that the exchange rate has positive and significant impact on house prices.
Based on the experience of various nations, one can identify a positive relationship between the appreciation of currency and real estate prices. In recent years, due to the growing expectation of appreciation of the RMB, substantial international capital has entered China through various channels to engage in short-term speculative investments through the acquisition of RMB assets in order to benefit from both the appreciation of the RMB and the rise in value of domestic assets.
Chu and Sing (2004) believed that the growth of real estate prices in China is largely because of a large influx of foreign capital into the market.
IMF (2007) maintained that under the circumstance of continued massive capital inflow, quickly rising costs can render sterilized intervention policies ineffective in preventing the appreciation of the domestic currency. In recent years, the rising costs of sterilized intervention in China has made such policies unsustainable and created asset pricing bubbles. The inflow of foreign speculative capital not only stimulates inflation, but also further accelerates the rise of stock prices and real estate market bubbles (Zhang and Fung, 2006). Guo and Huang (2010) utilized a multivariate VAR model with Markov regime-switching (MS) feature. Results of empirical analyses revealed that speculative capital inflows had aggravated short-term property prices and enhanced volatilities in both real estate and stock markets in China.
Short-term international capital inflows have not only caused domestic housing prices to go up but also escalated the fluctuation of housing prices in China. With RMB appreciation expectation, foreign investors have entered the Chinese market through various channels. Since the channels of investment are simple in China, all foreign investments ultimately converge in the real estate market, which is known for asset value preservation and appreciation. Liu and Wray (2010) analyzed two contending views of money and excess liquidity at both the theoretical and the practical levels. They related the analysis to China's skyrocketing credit expansion in 2009 and its relationship with the housing market boom. The conventional view is that such a bubble is highly dangerous and is largely caused by excess liquidity, which, in turn, induced Chinese banks to lend funds. This supposedly fueled the fire in real
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estate markets and also pushed up the stock market.
Real estate prices in China and investment-oriented real estate demands have grown steadily in the past few years and as a result, bubbles have gradually formed in the housing market. Real estate is a crucial asset, the development and sales of real estate are both closely tied to financial support. With China’s economy being so highly dependent on the nation’s real estate market, if the government fails to exercise appropriate control over international investment and speculative capital movement, the development of China’s real estate market may face daunting challenges.
The VAR model and the vector error correction model (VECM) have been widely employed in the current literature to investigate the effects of foreign capital on domestic asset prices, with an analytical emphasis on the impacts of short-term foreign capital inflow on real estate and stock markets. Despite the ignorance of the interactions among variables, these studies did not delve into the impacts of unsterilized portion of the monetary base on the domestic capital market.5 Accordingly, the present study uses a SVAR model and includes a variable for the unsterilized portion of the monetary base. In addition to exploring the effects of short-term foreign capital inflows and the unsterilized portion of the monetary base on asset prices in China, the extent to which rises in asset prices further attract short-term inflows of foreign capital is analyzed. These serve as references to maintaining financial stability in China.
3.3 An Overview of Short-term International Capital Inflows and Asset markets in China
Short-term international capital comprises short-term speculative funds that rapidly move between different countries in the world financial markets to pursue the highest interest rates and opportunities for getting maximum profits. A large-scale influx sharply raises asset prices of individual economies when speculative funds come in, fueling speculative bubbles and severely affecting the economic and financial system. In the context of appreciation of RMB being expected in recent years, large amounts of hot money have poured into China from every channel, purchasing properties and stocks and engaging in short-term speculation in order to obtain dual profits of rising Chinese asset prices and appreciation of RMB.
As short-term international capital has strong influence on China’s economy through the effect of money multiplier, large capital flight can have an immeasurable impact on China’s economic and financial stability. Accordingly, thorough
5 The unsterilized portion of the monetary base is defined as the current funds outstanding for foreign exchange minus the net value of the current issuance of central bank bills and the net value of the reserve requirements.
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understanding of short-term international capital movements and effects of short-term international capital on real estate and stock markets, along with measurements of and control over international short-term capital, is of great significance for maintaining stability in the macro economy and preventing financial crises. The following figures and data are used to explicate the status of real estate and stock markets and the recent movements of short-term international capital in China, and to explore possible impacts of international short-term capital on Chinese real estate markets and stock markets.
Since short-term international capital is by nature highly speculative, highly liquid and highly diversified, measuring its size becomes difficult. There has been no consensus on methods of measurement. For short-term international capital, two measurement methods have been employed in the literature. First, net errors and omissions in the balance of payments are used to estimate the size of short-term international capital inflows. Since net errors and omissions are used for balancing the balance of payment, they do not bear any real economic meaning. We thus employ the second method; we define short-term international capital as changes of foreign exchange reserves minus trade surplus and foreign direct investment (Zhang and Fung, 2006).
Table 3.1 shows that despite a slight decline in the amount of short-term
international capital flowing into China in 2008 due to influences of global financial crisis, it has risen steadily since 2005, reaching to 342,749.67 million USD in 2009.Afterwards, though it gradually decreased with time, showing a negative level in 2012, the impacts of short-term international capital on the domestic assets market are still substantial.
Figure 3.1 shows that Shanghai’s stock composite index declined for four years since 2000, a downfall of as much as half of the level in 2000. It began to rise substantially since 2005, reaching a record high of 4,300 on average in 2007. Then it began to dip continuously, reaching a record low of 2,200 in 2012, a drop of as much as 48.84%. The housing price at the same time showed slight upward fluctuations, increasing up to 1.77 times 2012 as compared to 2000, indicating that the Chinese real estate market was booming in that year.
China’s economic growth has remained strong in recent years, with growth rates of up to 10% being recorded from 2003 until 2007. After the global financial crisis in 2007, China’s economic growth slightly slowed to 9.6% in 2008 and once reached a record low of 9.3% in 2011, its second lowest rate of growth for nine years. However, in the context of global financial crisis, other major economies such as the United States and the European Union are almost in recession; global economic growth rates
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during the same period of time were only 3.7% and 4%. The Chinese market, comparatively speaking, is still a relatively active investment target.6
Table 3.1: Short-term International Capital Inflows in China ── 2000 to 2012
Unit: million USD
2000 10,899 2,009.08 40,772.00 -31,882.08 2001 46,591 1,878.83 46,878.00 -2,165.83 2002 74,242 2,534.08 52,743.00 18,964.92 2003 116,844 2,122.42 53,505.00 61,216.58 2004 206,681 2,674.83 60,630.00 143,376.17 2005 208,940 8,500.00 72,406.00 128,034.00 2006 247,428 14,789.58 72,715.00 159,923.42 2007 461,949 21,890.42 83,521.00 356,537.58 2008 417,781 24,843.92 108,312.44 284,624.64 2009 453,122 16,307.33 94,065.00 342,749.67 2010 448,186 15,125.42 105,735.24 327,325.34 2011 333,810 12,908.17 116,009.85 204,891.98 2012 130,441 19,204.33 111,716.14 -479.47 Note: This method we employ cannot exclude trade finance and capital movement among commercial
banks, thus causing the overestimation of short-term international capital inflows.
Source: Same as Figure 2.3.
As China’s economy is still growing steadily, even after the global financial crisis, short-term international capital targets Chinese real estate markets and stock markets since they have more arbitrage opportunities. Attracted by the expected appreciation of RMB and high profits in the asset market, continuous influx of short-term international capital contributes to unceasing increases in housing prices and volatility of stock prices. As shown in the figure, the amount of short-term
As China’s economy is still growing steadily, even after the global financial crisis, short-term international capital targets Chinese real estate markets and stock markets since they have more arbitrage opportunities. Attracted by the expected appreciation of RMB and high profits in the asset market, continuous influx of short-term international capital contributes to unceasing increases in housing prices and volatility of stock prices. As shown in the figure, the amount of short-term