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Challenges for Monetary Policy in China:

Challenges for Monetary Policy in China:. I. Overheating and Financial Depth, II. Adverse Selection and Credit Rating Error, III. Macro-economic Stability and Loan-Loss-Reserve Regulation. I. Overheating. Evidence of Overheating Inefficient Capital Allocation

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Challenges for Monetary Policy in China:

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  1. Challenges for Monetary Policy in China: I. Overheatingand Financial Depth, II. Adverse Selectionand Credit Rating Error, III. Macro-economic Stability and Loan-Loss-Reserve Regulation Stodder: Monetary Pollicy, July

  2. I. Overheating • Evidence of Overheating • Inefficient Capital Allocation • Informal Financial Intermediaries • Excessive Money Supply • Small Government Bond Market Stodder: Monetary Pollicy, July

  3. 1. Evidence of Overheating: Inflation Spike Source: CIA Factbook, and June 2007 Figures Stodder: Monetary Pollicy, July

  4. Evidence: Real Estate Prices Stodder: Monetary Pollicy, July

  5. Evidence: Shanghai Engineers’ Salaries Higher than in Thailand, Indonesia, Philippines Source: METI - China and ASEAN4 Stodder: Monetary Pollicy, July

  6. 2. Capital Allocation: State Banks to State-Owned Enterprises Source: McKinsey Stodder: Monetary Pollicy, July

  7. Capital Allocation: Too Scarce in Inland Areas Source: METI Stodder: Monetary Pollicy, July

  8. Capital Allocation: Can Heighten Regional Inequalities Stodder: Monetary Pollicy, July Source: METI

  9. 3. Money Supply: China’s M2/GDP out of proportion http://www.allcountries.org/china_statistics/index.html Stodder: Monetary Pollicy, July

  10. 4. Informal Finance: “ All small business start with loans from family and friends. I’m not aware of any business that was started with bank financing.” - Manager of one of Shanghai’s 10 largest Private Firms (McKinsey) Stodder: Monetary Pollicy, July

  11. Informal Financial Intermediaries 28% Source: McKinsey Stodder: Monetary Pollicy, July

  12. 5. Small Government Bond Market: Makes Central Bank’s Job More Difficult Source: McKinsey Stodder: Monetary Pollicy, July

  13. II. Adverse Selectionby Credit Rating Error • Think of two firms which must go through a long difficult process – just to achieve the same credit rating. • But say the 1st firm is a good risk, while the 2nd firm is a poor risk. (So there is Rating Error.) • Which firm will be more determined to complete the rating process? Stodder: Monetary Pollicy, July

  14. Empirically Based Simulation of Credit Rating Effects: • “Modeling the economic value of credit rating systems”, by Jankowitscha, Pichlera, and Schwaigerb Journal of Banking & FinanceVolume 31, Issue 1, January 2007, Pages 181-198 Stodder: Monetary Pollicy, July

  15. Adverse Selection: History of 30,000 Austrian Corporate Loans Source: Jankowitsch et. al., Journal of Banking & Finance (2007) Stodder: Monetary Pollicy, July

  16. Adverse Selection: Basis Point Improvement in Change from Low Credit Rating Accuracy Source: Jankowitsch et. al. (2007) Stodder: Monetary Pollicy, July

  17. Adverse Selection • The study finds this improvement in return is mostly due to less adverse selection – not better loan pricing. • As a very distinguished banker friend of mine once said: “If you lose the principle, it’s hard to make it up on interest payments.” Stodder: Monetary Pollicy, July

  18. III. Macro-economic Stability and Loan-Loss-Reserve Regulation “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way,along with his fellows, so that no one can really blame him.” • J.M. Keynes (1931) Stodder: Monetary Pollicy, July

  19. Macro Stability: Keynes noted the “Paradox of Thrift” • Consumers cut back on their spending and save more during a recession. This only makes the recession worse. • Similarly, Loan Loss Reserves (LLR) are often raised in a recession, just when banks can least afford them – often ensuring their collapse and worsening the recession. Stodder: Monetary Pollicy, July

  20. Macro Stability: Perverse Loan-Loss Regulation • Laeven, Luc & Majnoni, Giovanni, 2003. "Loan loss provisioning and economic slowdowns: too much, too late?,"Journal of Financial Intermediation, Vol. 12(2), April, pages 178-197. • Can be downloaded from World Bank: http://ideas.repec.org/p/wbk/wbrwps/2749.html Stodder: Monetary Pollicy, July

  21. They argue that LLR should be ‘pro-cyclical’, built up in good times, so that it is available for bad times. Stodder: Monetary Pollicy, July

  22. Instead, LLR growth ‘counter-cyclical’:Weak LLR in booms spurs inflation,Strong LLR in busts worsens recessions Stodder: Monetary Pollicy, July

  23. Tentative Conclusions: • China’s Monetary Policy challenge is very difficult, with few policy instruments • A good Credit Rating System has great potential for improved financial returns from banking • However, poor regulation based on credit rating has the potential to increase macro-economic instability Stodder: Monetary Pollicy, July

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